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When comparing companies that hold equity investments in other corporations, which of the following statements is most accurate? All else being equal, leverage measures for a firm using proportionate consolidation will appear:

A)	less favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method.

B)	less favorable than those for a comparable firm using consolidation, and more favorable than those for a comparable firm using the equity method.

C)	more favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method.

All else being equal, leverage measures for a firm using proportionate consolidation will appear more favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method. This is because the choice of accounting method will affect the value of the liabilities on the balance sheet, while the level of book equity remains the same.

When comparing companies that hold equity investments in other corporations, which of the following statements is most accurate? All else being equal, net profit margin measures for a firm using proportionate consolidation will appear:

A)	more favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method.

B)	less favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method.

C)	less favorable than those for a comparable firm using consolidation, and more favorable than those for a comparable firm using the equity method.

All else being equal, net profit margin measures for a firm using proportionate consolidation will appear more favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method. This is because the choice of accounting method will affect the level of sales, while the level of net income remains the same.

When comparing companies that hold equity investments in other corporations, which of the following statements is most accurate? All else being equal, return on asset measures for a firm using proportionate consolidation will appear:

A)	less favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method.

B)	more favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method.

C)	less favorable than those for a comparable firm using consolidation, and more favorable than those for a comparable firm using the equity method.

All else being equal, return on asset measures for a firm using proportionate consolidation will appear more favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method. This is because the choice of accounting method will affect the level of book assets, while the level of net income remains the same.

Which of the following methods of accounting for investments will reflect the highest assets and liabilities on a company’s balance sheet?

A)	Acquisition method.

B)	Equity method.

C)	Both methods result in reporting the same balances for assets and liabilities.

Which of the following methods of accounting for investments will reflect the highest net income on a company’s income statement?

A)	Acquisition method.

B)	Equity method.

C)	Both methods report the same net income.

A company reports an intercorporate investment using the acquistion method. Which of the following statements is most accurate?

A)	The use of the acquistion method by a company will generally report the most favorable results.

B)	The use of the proportionate consolidation method by a company will generally report the most favorable results.

C)	The use of the acquistion method by a company will generally report the least favorable results.

Milburne Company purchased 1,000 shares of Marino Co. for $20 per share on January 1. By December 31, shares of Marino were trading at $15 per share in the open market. Marino Co. has 100,000 shares outstanding with a dividend yield of 2% at year end. Milburne plans to hold the shares of Marino for longer-term investment and liquidity purposes. The impact of the Marino holding on the Milburne income statement is:

These securities are to be classified as available for sale and hence, all unrealized gains and losses are posted to a securities valuation reserve on the balance sheet. Hence, the only income statement impact is the $300 dividend = 0.02 × $15 × 1,000.

Milburne Company purchased 1,000 shares of Marino Co. for $20 per share on January 1. By December 31, shares of Marino were trading at $15 per share in the open market. Marino Co. has 100,000 shares outstanding with a dividend yield of 2% at year end. Milburne plans to hold the shares of Marino for near-term trading purposes. The impact of the Marino holding on the Milburne income statement is:

Since these securities are to be classified as trading securities, both the dividend received and the unrealized loss are posted to the income statement. The dividend is computed as 0.02 × $15 × 1,000 = $300 whereas the unrealized loss is $5,000 = ($15 - $20) × 1,000. The net income statement impact is $300 - $5,000 = -$4,700.

On December 31, 2008 Company P invests $5,000 in Company S in exchange for 25% of the company. During 2009, Company S earns $2,000 and pays a dividend of $500. If Company P uses the equity method of accounting, what values will be reported on the balance sheet and income statement? How much cash will be recognized from the investment?

The carrying value on the balance sheet is $5,375, the income statement will show $500 of income, and the cash recognized is equal to the dividend of $125.
Using the equity method, for 2008, Company P will:

Recognize $500 ($2000 × 0.25) on its income statement as equity in the net income of Company S.
Increase the investment in the Company S account on the balance sheet to $5,500, reflecting its share of the net assets of Company S.
Receive $125 in cash dividends from Company S and reduce its investment in Company S by that amount to reflect the decline in the net assets of Company S due to the dividend payment.

At the end of 2008, the carrying value of Company S on Company P’s balance sheet will be ($5,000 original investment + $500 proportional share of Company S earnings – $125 dividend received = $5,375).

Assume that Fiduciary reclassified securities ($10 million carrying value, $8 million market value) from Portfolio B into Portfolio A under U.S. GAAP. If no previous write downs were made, Fiduciary must:

A)	charge $2 million to its income statement.

B)	charge $2 million to the equity section of its balance sheet.

C)	do nothing to its income statement or equity section of its balance sheet.

U.S. GAAP allows investment managers some latitude in reclassifying investment assets from “trading” to “available-for-sale.” Unrealized gains and losses are recognized on the income statement. IFRS severely restricts reclassification out of the held-for-trading category.

The Anderson Company acquired 100,000 shares of the Birschbach Company on January 1, 2000, at $25 per share. The market price of a share of Birschbach stock on December 31, 2000, was $35 per share. During 2000, Birschbach paid dividends of $1.50 per share and had earnings of $2.50 per share.

If Anderson Company accounts for the Birschbach Company shares using the equity method, the carrying amount of these shares on Anderson's balance sheet at the end of 2000 is:

Under the equity method market value is ignored so the carrying value of the shares is the original investment + proportional share of earnings ? dividend received.

[(100,000)($25)] + [(100,000)($2.50 ? 1.50)] = $2,600,000

Under the available-for-sale accounting method unrealized gains and losses are not recognized on the income statement so the only impact on the income statement is the dividend received:

(100,000 shares)($1.50 per share) = $150,000

On December 15, 2009, the Zeisler Company faces a financial crisis. Zeisler’s industry has gone into recession and net income has declined to nearly zero. Jeremiah Welch, the company’s CFO, is extremely concerned that, when the final figures for 2009 come in, the poor operating results will throw the firm into violation of its debt covenants, which specify that it must meet a certain return on assets (ROA) and not exceed a certain debt-to-asset ratio. A violation of either covenant would trigger a provision in the lending agreement allowing lenders to put Zeisler’s debt back to the firm and likely force Zeisler into bankruptcy.

With only two weeks before the close of the firm’s fiscal year on December 31, there is no way to avoid bankruptcy through improved operations. Welch calls an emergency meeting with Olivia Dupree, the firm’s controller, to come up with a plan of action to keep Zeisler out of bankruptcy. He explains to Dupree that they need to increase Zeigler’s reported ROA and reduce its reported debt-to-assets ratio relative to the numbers that would otherwise be reported for 2009.

Dupree suggests that Zeisler’s equity investments might be useful in staving off bankruptcy. Zeisler acquired 100,000 shares of the Market Square Corporation on January 1, 2009, at $25 per share. Market Square paid dividends during 2009 of $1.50 per share and was expected to have earnings for 2009 of $2.50 per share. Zeisler also holds 250,000 shares of General Nuclear, purchased for $72 per share. General Nuclear has no dividends and is expected to report a loss for 2009. Both securities are classified on the financial statements as available-for-sale.

Dupree added that Zeisler also holds several million dollars of Market Square’s debt securities, classified as a held-to-maturity investment. The holding in Market Square represents a small fraction of Zeisler’s total fixed-income investments, all of which are also classified as held-to-maturity. The investment in Market Square’s debt differs significantly from Zeisler’s other investments in fixed-income securities in that Market Square’s debt is trading slightly above Zeisler’s cost while Zeisler’s other fixed-income investments are all trading significantly below Zeisler’s cost because of a general increase in market interest rates. Welch points out, however, that even if the firm were to sell all its marketable securities, the proceeds would not be sufficient to pay off the debt and avert bankruptcy.

Dupree left the meeting with Welch for a moment to check the stock market. She found that Market Square was trading at $35 per share and General Nuclear was at $43. This new information gave Dupree an idea.

Dupree suggested to Welch, “We could reclassify our equity investment in Market Square as trading before year-end. That will help raise our ROA for this year.” Welch pointed out that a reclassification of the equity investment from available-for-sale to trading would reduce Zeisler’s reported net income because the firm would be required to stop including the dividends it receives from Market Square in net income.

Welch suggested that, instead of reclassifying Market Square’s equity, they sell Market Square’s debt. That would reduce Zeisler’s debt-to-assets ratio because the unrealized gain in the market value of the Market Square debt would be realized when the security was sold. Dupree added that the firm could also liquidate the General Nuclear investment to raise cash without affecting the firm’s reported ROA for 2009. Welch and Dupree decided to liquidate the two assets to help improve the firm’s financial position.

What is the investment income that Zeisler Company will report for the year 2009 on its investment in Market Square Corporation shares if it continues to account for the shares as an available-for-sale investment?

The investment income for available-for-sale securities includes dividends, interest, and realized gains. In this case, the investment income from Market Square Corporation would be the dividends it paid to the number of shares Zeisler owns:

100,000 shares × $1.50 per share = $150,000. (Study Session 6, LOS 23.c)

Trading securities are carried at fair market value:

100,000 shares × $35 per share = $3,500,000. (Study Session 6, LOS 23.c)

A)	Net income would increase.

B)	Reclassifying the security would have no effect on the income statement because gains and losses would be recognized in equity.

C)	Net income would decline.

Reclassifying a security from available-for-sale to trading requires unrealized gains and losses to be recognized in income. Since Zeisler’s investment in General Nuclear has an unrealized loss, net income would be reduced. (Study Session 6, LOS 23.c)

A)	Welch’s statement is incorrect; Dupree’s statement is correct.

B)	Welch’s statement is correct; Dupree’s statement is incorrect.

C)	Welch’s statement is incorrect; Dupree’s statement is incorrect.

Welch’s statement is incorrect because dividends and interest are recognized as income both when the securities are classified as trading and when they are classified as available-for-sale.

Dupree’s statement is correct. Reclassifying the securities from available-for-sale to trading will significantly raise Zeisler’s near-zero net income by allowing Zeisler to recognize the unrealized gain in income when the security is reclassified. It will have no material effect on asset value because the shares will be carried at fair market value as trading securities and were already carried at fair market value (with the net unrealized gain in equity) as available-for-sale securities. Even though it may appear that equity would decline by the amount of the unrealized gain if the securities were reclassified, the unrealized gain will flow through income in 2009 and thus return to equity. Consequently, reclassifying the equity securities of Market Square would help increase Zeisler’s ROA by raising net income and having little effect on assets. (Study Session 6, LOS 23.c)

Under the equity method the market value of the stock is ignored but the proportionate share of the earnings are added to the original investment and the proportionate share of the dividends are subtracted from the earnings. Hence, we have the original investment + (earnings ? dividends) = total value of the investment.

[(100,000 shares)($25)] + [(100,000 shares)($2.50 earnings ? 1.50 dividend)] = $2,600,000. (Study Session 6, LOS 23.c)

A)	Welch’s statement is correct; Dupree’s statement is incorrect.

B)	Welch’s statement is correct; Dupree’s statement is correct.

C)	Welch’s statement is incorrect; Dupree’s statement is incorrect.

Welch’s statement is incorrect because accounting standards require a firm that sells a held-to-maturity security before maturity to carry its remaining held-to-maturity securities at market value instead of cost. Since the Market Square debt is the only fixed-income investment trading above Zeisler’s cost, and it represents only a small part of Zeisler’s total fixed-income portfolio, the net effect of selling the Market Square debt would be to reduce assets (not raise them) because it would require Zeisler to mark down all its other fixed-income investments. A decline in assets would effectively increase the debt to assets ratio.

Dupree’s statement is also incorrect. The investment in General Nuclear would be carried on the books at fair market value, with the unrealized loss in equity. Selling the asset and converting it to cash would not materially affect total assets. However, selling the General Nuclear shares would reduce net income because the realized loss would have to be recognized in income. Thus, the sale would reduce reported ROA. (Study Session 6, LOS 23.c)

On January 9, 2006, Company X paid $2,000,000 for 100,000 shares of stock in Company S. Originally the company intended on holding the securities for the foreseeable future. As of December 31, the stocks were valued at $2,200,000. In 2006, Company S had earnings per share of $0.90 and paid dividends per share of $0.20. In late December 2006, the company decided to place the securities in their active marketable securities portfolio.

What is the impact of this change in status on the value of the assets of Company X?

The stocks were classified as debt and equity securities available for sale, but now they will be classified as debt and equity trading securities. However, although it will affect net income, the change in status will not impact the reported value of the assets. According to SFAS 115, securities transferred from available-for-sale to trading securities are transferred at fair market value and unrealized gains or losses would be included in income.

A)	Stockholders' equity will rise by $200,000, but income will not change.

B)	Income will rise by $200,000, but stockholders' equity will not change.

C)	Income and stockholder's equity will rise by $200,000.

The stocks were classified as debt and equity securities available for sale, but now they will be classified as debt and equity trading securities. The gain would have been reported in the securities valuation account in the equity section and not on the income statement, but now will be reported as income.

Which of the following statements about proportionate consolidation and the equity method is least accurate?

A)	In a proportionate consolidation, the analyst adds the investor's pro-rata share of each of the affiliate's asset and liability accounts to the historical cost financial statements of the investor.

B)	The equity balance under a proportionate consolidation will differ from that of the equity method because the investor records his pro-rata share of the equity of the affiliate firm in a proportionate consolidation.

C)	Total assets under proportionate consolidation will most likely exceed the total assets reported under the equity method.

A)	Minority interest is computed and shown on a proportionate consolidation balance sheet and income statement.

B)	Under the proportionate consolidation method, all asset and liability accounts are added together using original historical costs.

C)	The porportionate consolidation method is employed by analysts to better reflect the economic reality of the relationship between an investor and affiliate company which is currently accounted for under the equity method.

The proportionate consolidation method is most appropriate when two firms have entered into a joint venture relationship but the investor accounts for the investment under the equity method because it owns between 20 and 50% of the outstanding shares of the JV. The proportionate consolidation method is used by analysts to better reflect the true economic linkage between the JV and the investor firm. The equity method provides nothing more than a "one-line" consolidation.

Joseph Haggs, CFA, is an analyst working for Garvess Jones, a large publicly traded investment-baking firm. Haggs covers the Internet sector. Recently, one of the more successful companies Haggs covers, Simpson Corporation, made an aggressive move to acquire another Internet company, Bailey Corporation (BC). BC is a company specializing in graphics and animation on the World Wide Web and has 1,000,000 shares outstanding. Simpson also holds minimal investments in other technology companies both public and private. In 1999 Simpson saw an opportunity to substantially increase its share in BC. Simpson feels that their sophisticated animation can greatly improve Simpson's market share and sees an acquisition as an opportunity to expand their business. The relevant financial data are in the following tables.

Because this is the largest acquisition in Simpson's history, Mr. Haggs' supervisor has asked him to prepare a report for Garvess Jones' clients detailing the affects of the acquisition on Simpson's financial statements.

Haggs wonders which accounting method Simpson uses to calculate the book value of the BC investment for the year ending December 31, 1999. Which is the correct method?

A)	Equity method.

B)	Acquisition method.

C)	Investment in Financial Assets method.

A)	Equity method.

B)	Investment in Financial Assets method.

C)	Acquisition method.

Simpson paid a total of $?3,190,000 (290,000 shares × $11) however, they also received a dividend from BC of $360,000. For 1999 Bailey Corporation is paying $1.20 in dividends per share (1,200,000 / 1,000,000). As of December 1999, Simpson has purchased 300,000 shares of BC (= 290,000 + 10,000). So dividends received is 300,000 × $1.20 = $360,000. This will make the total cash flow for the year $?2,830,000.

Assume that on the balance sheet date shown below TME Corporation acquires 70% of Abcor, Inc. common stock for $25,000 in cash.

What will be the post-acquisition current ratio, using both the acquistion method and the equity method, respectively, for TME? The choices below represent Acquisition and Equity, respectively.

With the acquisition method: The current assets are ($80,000 + $38,000 - $25,000) = $93,000. The current liabilities are ($60,000 + $32,000) = $92,000. The current ratio is $93,000/$92,000 = 1.01. With the equity method: The current assets are ($80,000 - $25,000) = $55,000. The current liabilities are $60,000. The current ratio is $55,000/$60,000 = 0.92.

Using the acquisition basis of accounting, the post-acquisition level of the current assets is the amount of the current assets prior to acquisition minus the amount of cash used for the acquisition. ($80,000 + 38,000 – 25,000) = $93,000.

Since only 70% of Abcor was purchased by TME there is a minority interest that must be accounted for, equal to the percentage of Abcor not owned by TME times Abcor’s net worth. (0.30)($53,000 – 32,000) = $6,300.

A)	same net income as the equity method.

B)	different net income from the equity method.

C)	same equity as the cost method.

The proportionate consolidation method will least likely achieve the same results as the acquisition method because:

A)	there are no minority interests.

B)	of the use of the equity method on the income statement.

C)	no joint ventures are included.

Mustang Corporation formed a special purpose entity (SPE) for purposes of providing research and development. An unrelated firm absorbs the expected losses of the SPE and the independent shareholders of the SPE receive the expected residual returns. Is the SPE considered a variable interest entity (VIE) according to FASB Interpretation No. 46(R) and is consolidation required by Mustang, respectively?

Firm A recently leased equipment used in its manufacturing plant. If the leased asset is worth less than $100,000 at the end of the lease, Firm A will pay the lessor the difference.

Firm B provided debt financing to an unrelated entity. The debt has a provision whereby Firm B cannot be repaid until all other senior debt is satisfied.

A)	Only one has a variable interest.

B)	Neither have a variable interest.

C)	Both have a variable interest.

A lease residual guarantee and subordinated debt are both examples of variable interests. Firm A will experience a loss if the leased asset is worth less than $100,000 at the end of the lease. Firm B will experience a loss if the senior debt is not paid in full.

Which of the following securities would most likely be characterized as a held-to-maturity security?

Accounting standards for intercorporate investments establish different categories of securities with distinct ways of treating them on the financial statements of the company. One category requires the securities to be carried at fair value on the balance sheet with unrealized gains and losses excluded from the income statement. This category of security classification is called debt:

A)	securities held-to-maturity.

B)	and equity trading securities.

C)	and equity securities available-for-sale.

If securities are designated as debt and equity securities available-for-sale they can be sold to meet the liquidity and other needs of the company. As such, the securities are to be carried at fair value on the balance sheet with unrealized gains and losses excluded from the income statement.

Which of the following statements is INCORRECT regarding the classification of debt and equity security investments?

A)	If equity and debt securities are available-for-sale securities, any realized and unrealized gains and losses are reported in the income statement.

B)	If equity and debt securities are trading securities, any realized and unrealized gains and losses are reported in the income statement.

C)	Debt held-to-maturity is reported in the balance sheet at amortized cost.

Accounting standards for passive intercorporate investments include a category of securities that is carried on the company balance sheet at cost. This category of securities is called debt:

A)	securities held-to-maturity.

B)	and equity trading securities.

C)	and equity securities available-for-sale.

Which of the following statements about the various classifications of securities held by a firm is least accurate?

A)	Trading securities are, by definition, current assets because the firm intends to trade these securities in the near term.

B)	Equity securities of other companies cannot be classified as "held to maturity" under SFAS 115.

C)	A firm which invests in the debt securities of another firm cannot classify these securities as "held to maturity" if they have the positive intent and ability to hold the securities until final maturity.

Accounting standards for passive intercorporate investments establish different categories of securities with distinct ways of treating them on the financial statements of the company. Which of the following categories requires realized and unrealized gains and losses to be reported as income? Debt:

A)	and equity trading securities.

B)	securities held-to-call.

C)	and equity securities available-for-sale.

Accounting standards for passive intercorporate investments include, debt and equity trading securities, is for securities that, when acquired, are intended to be resold within a near term time horizon. They are classified as current assets on the balance sheet, with any realized or unrealized gains and losses reported as income.

Which of the following statements regarding securities classified as held to maturity is most accurate?

A)	Equity securities can be classified as "held to maturity" if the security pays a large and consistent dividend and management has decided to hold the security for more than five years.

B)	Only debt securities can be classified as "held to maturity" securities.

C)	Equity securities can be classified as "held to maturity" if the firm's management has decided to hold the security for more than five years.

Which of the following securities will most likely be characterized as an available-for-sale security?

A)	Debt or equity securities that are carried on the balance sheet at fair market value and may be sold for liquidity purposes.

B)	Debt securities that a company has a positive intent and ability to hold to maturity.

C)	Equity securities representing 30% ownership in another firm.

A)	debt and equity securities acquired with the intent of selling them in the near future.

B)	debt and equity securities that are very liquid and easy to sell.

C)	equity securities representing 20% to 50% ownership in a public firm.

Cosmo Inc. (Cosmo) invests in two portfolios – Portfolio 1 and Portfolio 2. Portfolio 1 contains securities with an overall intent to profit within a month or two. Portfolio 2 contains equity securities with a moderate amount of acquisition and disposition activity. Which of the following treatments of Cosmo’s reporting of the investments in Portfolios 1 and 2, respectively, is most accurate?

Unrealized amounts reported on balance sheet.

Assets reported at fair value.

Unrealized amounts reported on income statement.

Assets reported at cost.

Unrealized amounts reported on income statement.

Assets reported at fair value.

Portfolio 1 contains held-for-trading securities because it is clear that the securities are acquired with the intent to profit over the near term. Therefore, the unrealized gains and losses would be reported immediately in the income statement.

Portfolio 2 contains available-for-sale securities. There are no debt securities and therefore, it cannot contain held-to-maturity securities. As well, there is no indication that the securities are acquired with the intent to profit over the near term. By default, the correct classification would be available-for-sale. Therefore, the securities (assets) would be reported at fair value.

Omricon Capital Associates specializes in making investments in the small cap market sector. In some cases the firm operates as a supplier of private equity for restructurings. In this instance, the firm views itself as having a value investment focus. In others, it acts as a venture capital firm. Here, the investment focus is usually growth. Finally, in some cases it simply takes passive investment positions in publicly-traded firms. The positions in marketable securities are sometimes considered trading positions, and other times the view is to hold for a longer period until valuation parameters are met or exceeded.

Omricon’s chief compliance officer, Raymond “Buzz” Richards has recently become concerned that the firm may not be correctly following the relevant accounting standards for these investments. To ensure that the rules are being effectively adhered to, he is seeking advice from the accounting firm of Merz-Brokaw and Associates on the matter. Sally Lee is the Merz-Brokaw partner heading up the consulting team assigned to review the situation.

The size of the investments ranges from a few percent of the firm’s outstanding equity, to positions of greater than 50%. Richards says that it has always been his understanding that the percentage of the equity held is the major determinant with respect to which accounting method applies. Lee reminds him that the firm’s intent for its investments also plays a role in determining how they are accounted for.

Some of the firm’s investments have not worked out as planned. Richards has conferred with the firm’s portfolio managers regarding securities being held by the firm that are worth less than when they were acquired, and has presented a list of these investments to Lee. His concern is what this implies for the accounting for these investments. Lee tells him that the issue here is whether or not the security can be considered impaired, and that designating a security as impaired implies that the decline in value is permanent.

Top managers at Omricon have asked Lee to help them evaluate the impact of the choice of accounting method on the firm’s profitability. Some members of the management team are of the belief that the accounting method does not affect financial measures because these are driven by underlying economic factors. Others believe that these measures can be affected by the accounting method chosen.

Which of the following statements concerning percentage ownership and accounting method is most accurate?

A)	When the ownership is less than 20%, both US GAAP and IFRS require the investment in financial assets method.

B)	When the ownership is less than 20%, US GAAP requires the investment in financial assets method, IFRS the equity method.

C)	When the ownership is less than 20%, both US GAAP and IFRS require the equity method.

A)	IFRS and US GAAP both permit a choice between the equity method and proportional consolidation.

B)	IFRS requires that the equity method be used; US GAAP permits a choice between the equity method and proportional consolidation.

C)	US GAAP requires that the equity method be used; IFRS permits a choice between the equity method and proportional consolidation.

When the percentage ownership is exactly 50% (i.e., the investment is a joint venture), IFRS allows for the choice between the equity method and proportionate consolidation, while US GAAP requires the equity method. (Study Session 6, LOS 23.b)

A)	marketable securities, available-for-sale securities, held-to-maturity securities.

B)	trading securities, available-for-sale securities, held-to-maturity securities.

C)	trading securities, marketable securities, held-to-maturity securities.

The three classifications for passive investments in securities that trade in secondary markets (i.e., marketable securities) are trading securities, available-for-sale securities, and held-to-maturity securities. (Study Session 6, LOS 23.a)

A)	US GAAP requires that unrealized gains and losses are reported on the income statement, while under IFRS the firm can elect to report on either the income statement or in comprehensive income on the balance sheet.

B)	IFRS requires that unrealized gains and losses are reported in comprehensive income on the balance sheet, while under US GAAP the firm can elect to report on either the income statement or in comprehensive income on the balance sheet.

C)	US GAAP and IFRS require that unrealized gains and losses are reported as equity in other comprehensive income on the balance sheet.

When a passive investment in marketable equity securities is classified as available-for-sale, US GAAP and IFRS require that unrealized gains and losses are reported as equity in other comprehensive income on the balance sheet. (Study Session 6, LOS 23.b)

A)	decline in value is permanent, its value should be written down to the new fair value, and a loss reported on the income statement.

B)	decline in value is other than temporary, its value should be written down to the new fair value, and a loss reported in comprehensive income in equity on the balance sheet.

C)	decline in value is other than temporary, its value should be written down to the new fair value, and a loss reported on the income statement.

A security should be considered impaired when the decline in value is “other than temporary”. That is to say that it is obviously not due to a temporary decline in the market. No one knows for sure if any decline in value is permanent, but in most cases it is obvious that it is not simply a market phenomenon. When this is the case, the asset’s value should be written down to the new fair value, and a loss reported on the income statement. (Study Session 6, LOS 23.a)

A)	ROA being higher and leverage being higher than under proportionate consolidation.

B)	ROA being lower and leverage being higher than under proportionate consolidation.

C)	ROA being higher and leverage being lower than under proportionate consolidation.

In most cases, the choice of the equity method will result in leverage being lower, net profit margin being higher, and ROA being higher than would be the case under proportionate consolidation. (Study Session 6, LOS 23.c)

Company X owns 15% of company S and exerts significant influence over the operations of the company. The book value of the investment on December 31, 2001, is $48,000. In 2002, company S earned $100,000 and paid dividends of $20,000. The value of the investment account on December 31, 2002, is:

Because company X exerts significant influence over company S, the investment will be treated using the equity method, even though the ownership is less than the 20% guideline. The value of the investment account is equal to the beginning balance plus the proportionate income of company S minus the dividends received from company S, which equals 48,000 + (0.15 x 100,000) ? (0.15 x 20,000) = 60,000.

Harter Company recently acquired a 40% stake in Compton Corp. for $40 million in cash by borrowing at 10%. Harter will account for this acquisition using which of the following methods:

A)	Acquisition Method.

B)	Equity method.

C)	Held to maturity debt securities method.

Sawbuck Corporation recently acquired a 60% stake in Rawboard Inc. for $70 million in newly issued common stock. Given this information, which of the following methods should be used to account for the acquisition of Rawboard?

Company X owns 15% of company S and exerts significant control over the operations of the company. The book value of the investment on December 31, 2008, is $48,000. In 2009, company S earned $100,000 and paid dividends of $20,000. The impact of the investment on the income statement of company X is:

Because company X exerts significant control over company S, the investment will be treated using the equity method, even though the ownership is less than the 20% guideline. The impact on the income statement is the proportionate income of company S, which is 0.15 × 100,000 = 15,000.

Acme Corporation purchases a 3% interest in Bandy Company to become the single largest shareholder of Bandy. Acme will hold a seat on the Board of Directors of Bandy. Acme will account for its investment in Bandy using the:

GTH Corporation has just purchased 18% of the common stock of Pittor Corporation, one of their major suppliers, making GTH the largest single shareholder in Pittor. The primary motivation for the purchase is that managerial problems at Pittor have resulted in quality control difficulties, thereby affecting the reliability of several critical component parts for GTH products. At the time of the purchase, GTH management announced they plan to be an active and significant influence on Pittor so the quality problems can be resolved. Given these circumstances, the accounting method used to record the intercorporate investment will most likely be the:

A)	acquisition method

B)	investment in financial assets method.

C)	equity method.

Less than 20% ownership of the acquired corporations common stock would ordinarily mean the cost or market method of accounting would be used to record this investment in financial assets. However, percentage ownership rules are guidelines only and the appropriate accounting method is dependant on the degree of influence the acquirer intends to exert. In this case, GTH has announced their desire to exert significant influence, hence, the equity method is the appropriate choice.

Carter Schmitz, Inc. (Schmitz) purchased 200 shares of Intelismart at $21 a share in June 2006 and intends to actively trade 80 shares in the near future and hold the remaining 120 shares as available for sale securities. Intelismart's closing price was $26 on December 31, 2006, and Schmitz did not sell any of its shares.

What amount should Schmitz report on this investment under the income statement?

The unrealized gain on the 120 shares available for sale is $600 (26 - 21 = 5 × 120 shares). There is also an unrealized gain of $400 (5 × 80) related to the 80 shares that are trading securities which would be reported on the income statement. For trading securities, realized and unrealized gains and losses are reported on the income statement. For available for sale securities, only realized gains and losses are reported on the income statement.

If the Anderson Company accounts for the Birschbach shares as trading securities, the carrying amount of these shares on Anderson's balance sheet at the end of 2000 is:

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

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.

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.

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.

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.

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

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

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.

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.

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

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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:

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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 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.

Under which of the following is a minority interest account most likely to appear on the consolidated balance sheet?

Proportionate consolidation is similar to a business acquisition, except the investor only reports the proportionate share of the assets, liabilities, revenues, and expenses of the joint venture. Since only the proportionate share is reported, no minority owners’ interest is necessary.

Bailey Corporation
Selected Financial Data, Years Ended December 31
(in Thousands)

Item	1998	1999	2000
Sales	$50,000	$60,000	$70,000
Less: cost of goods sold (COGS)	37,000	43,700	47,250
Earnings before interest & taxes (EBIT)	13,000	16,300	22,750
Less: Interest	10,000	13,000	19,000
EBT	3,000	3,300	3,750
Less: Taxes	1,000	1,100	1,250
Net Income	$2,000	$2,200	$2,500
Dividends Paid	$1,000	$1,200	$1,500
Total Shares Outstanding	1,000,000

Simpson’s Purchase Transactions in BC’s Stock
Date	January 1, 1998	January 1, 1999	January 1, 2000
Number of Shares	10,000	290,000	700,000
Price per Share	10	11	15

Pre-acquisition Balance Sheets December 31, 2001
	TME Corp.	Abcor, Inc.
Current assets	$80,000	$38,000
Other assets	28,000	15,000
Total assets	$108,000	$53,000

Current liabilities	$60,000	$32,000
Common stock	15,000	14,000
Retained earnings	33,000	7,000
Total liabilities and equity	$108,000	$53,000

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.

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

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.