Accounting Exam 3

How is the accounting method determined for investments in equity securities (stocks of another company)?

• It depends on the percentage of outstanding stock owned:

1. Ownership of LESS THAN 20%: Accounted for using the Fair Value/Mark-to-Market method.

2. Ownership of 20% OR MORE: Accounted for using the Equity Method.

What are the 4 accountable events for investments where ownership is LESS THAN 20%?

1. Acquisition: Record the investment at cost.

2. Receipt of Dividends: Record as Dividend Revenue.

3. Year-End Adjustment: Record a Mark-to-Market adjusting entry to adjust the asset to current market value (unrealized gain/loss).

4. Sale of Investment: Record cash received and any realized gain or loss.

What is the Mark-to-Market adjustment, and which accounting principle is it an exception to?

It is a year-end adjusting entry that changes the valuation of the investment asset on the balance sheet from its cost/current balance to its current market value. It is an exception to the Historical Cost Concept.

What is the difference between a Realized Gain/Loss and an Unrealized Gain/Loss?

• Realized Gain/Loss: Resulting from the actual SALE of investments.

• Unrealized Gain/Loss: Resulting from market value CHANGES during the year-end mark-to-market adjustment (no sale occurred).

• Note: Both types appear on the Income Statement.

What is the journal entry and financial statement impact when PURCHASING investments (<20% ownership)?

• Journal Entry: Debit: Investments Credit: Cash

Impact:

• Income Statement: No effect.

• Balance Sheet: Increases Assets (Investments) and decreases Assets (Cash).

• Cash Flow Statement: Investing Cash Outflow.

What is the journal entry and financial statement impact when RECEIVING DIVIDENDS (<20% ownership)?

• Journal Entry: Debit: Cash Credit: Dividend Revenue

Impact:

• Income Statement: Increases Revenues (Dividend Revenue), which increases Net Income.

• Balance Sheet: Increases Assets (Cash) and increases Equity (Retained Earnings).

• Cash Flow Statement: Operating Cash Inflow.

What is the journal entry and financial statement impact when RECORDING A MARK-TO-MARKET GAIN (<20% ownership)?

• Journal Entry: Debit: Investments Credit: Unrealized Gain

Impact:

• Income Statement: Increases Revenues (Unrealized Gain), which increases Net Income.

• Balance Sheet: Increases Assets (Investments) and increases Equity (Retained Earnings).

• Cash Flow Statement: NO EFFECT on cash.

What is the journal entry and financial statement impact when RECORDING A MARK-TO-MARKET LOSS (<20% ownership)?

• Journal Entry: Debit: Unrealized Loss Credit: Investments

Impact:

• Income Statement: Increases Expenses/Losses (Unrealized Loss), which decreases Net Income.

• Balance Sheet: Decreases Assets (Investments) and decreases Equity (Retained Earnings).

• Cash Flow Statement: NO EFFECT on cash.

How do you calculate the Realized Gain or Loss when SELLING an investment (<20% ownership)?

• Compare the Cash Selling Price to the balance carrying value of the investments on the Balance Sheet:

• Selling Price > Balance Sheet Carrying Value = Realized Gain (Credit)

• Selling Price < Balance Sheet Carrying Value = Realized Loss (Debit)

What accounting method is used for investments where ownership is 20% or MORE? Is there a Mark-to-Market adjustment?

The Equity Method. There is NO mark-to-market adjustment under the equity method.

What are the 4 accountable events under the EQUITY METHOD (>=20% ownership)?

• 1. Acquisition: Record investment at cost.

2. Dividends Received: Record as a DECREASE to the Investment account (NOT revenue).

3. Net Income Reported by investee: Record your share as an INCREASE to the Investment account and as Investment Revenue.

4. Sale of Investment: Compare selling price to the investment account balance to record cash and realized gain/loss.

Under the Equity Method, how are DIVIDENDS received recorded, and what is the financial statement impact?

• Journal Entry: Debit: Cash (Dividends Received = Total Dividend x % Ownership) Credit: Investments

Impact:

• Income Statement: NO EFFECT (it is treated as a return of capital, not revenue).

• Balance Sheet: Increases Assets (Cash) and decreases Assets (Investments).

• Cash Flow Statement: Operating Cash Inflow.

Under the Equity Method, how is the investee's NET INCOME recorded, and what is the financial statement impact?

• Journal Entry: Debit: Investments (Investee Net Income x % Ownership) Credit: Investment Revenue

Impact:

• Income Statement: Increases Revenues (Investment Revenue), which increases Net Income.

• Balance Sheet: Increases Assets (Investments) and increases Equity (Retained Earnings).

• Cash Flow Statement: NO EFFECT on cash.

Under the Equity Method, what increases and decreases the Investments T-account balance over time?

• Beginning Cost + Increases Investment account

• Your share of Net Income + Increases Investment account

• Dividends received - Decreases Investment account

• Sale/disposal of shares - Decreases Investment account

Under the Equity Method, how is the Gain or Loss on Sale calculated when the investment is sold?

• Compare Cash Received to the current balance in the Investments T-account: Gain or Loss = Cash Received - Current Investments Account Balance

• If Cash Received > Investment Account Balance = Realized Gain (Credit)

• If Cash Received < Investment Account Balance = Realized Loss (Debit)

What are the key differences between Debt Financing and Equity Financing?

• Debt Financing: Involves loans that must be repaid with interest; company is legally liable; relationship ends upon full repayment.

• Equity Financing: No legal responsibility to repay investors; investors take on risk and are rewarded through the company’s future success.

What are the two main categories of Stockholders' Equity?

1. Contributed Capital: The total amount invested by owners through purchasing stock (Capital Stock + Paid-in Capital).

2. Retained Earnings: Cumulative net income earned by the company that has not been distributed as dividends.

What are the main characteristics of Preferred Stock vs. Common Stock?

• Preferred Stock: Has dividend preference (paid before common stockholders); dividends are set at a fixed percentage; usually has NO voting rights.

• Common Stock: Has voting privileges (board elections, major corporate decisions); dividend rate determined by board based on profitability; receives dividends after preferred stockholders.

What is Par Value, and how does it affect stock issuance accounting?

• Par value is an arbitrary monetary amount assigned to stock for accounting purposes (has no relation to market value).

• Rule: Stock accounts (Common Stock / Preferred Stock) are ONLY credited for par value.

• Any excess cash received over par value is credited to Paid-In Capital.

What is the journal entry and financial statement impact when issuing Stock above Par Value?

• Journal Entry: Debit: Cash (Total Shares x Issue Price) Credit: Common Stock (or Preferred Stock) (Total Shares x Par Value) Credit: Paid-In Capital - Common (or Preferred) (Difference)

Impact:

• Income Statement: NO EFFECT (transactions in a company's own stock NEVER affect net income).

• Balance Sheet: Increases Assets (Cash) and increases Equity (Stock + Paid-In Capital).

• Cash Flow Statement: Financing Cash Inflow.

What are Authorized, Issued, and Outstanding shares?

• Authorized Shares: Maximum number of shares the company is legally allowed to sell.

• Issued Shares: Total number of shares that have been sold to the public.

• Outstanding Shares: Total number of shares currently held by stockholders (Issued Shares minus Treasury Shares).

What is Treasury Stock, and what type of account is it?

• Treasury stock represents shares of a company's own stock that were issued and later reacquired by the company.

• Account Type: Contra-Equity account (normal DEBIT balance).

• Balance Sheet Effect: Reduces total Stockholders' Equity.

• Key Rule: Recorded at RE-ACQUISITION COST (not par value).

Do Treasury Stock shares have voting rights or receive dividends?

No. Treasury shares are considered issued but NOT outstanding, so they cannot vote and cannot receive dividends.

Why would a corporation reacquire its own stock as Treasury Stock?

1. To reduce shares outstanding and increase market value per share.

2. To remove shares from the open market to prevent a hostile takeover.

3. To use for employee stock option plans.

4. To return cash to existing shareholders.

What is the journal entry when a company REACQUIRES its own stock (Treasury Stock)?

• Journal Entry: Debit: Treasury Stock (Shares x Reacquisition Cost) Credit: Cash

Impact:

• Income Statement: NO EFFECT.

• Balance Sheet: Decreases Assets (Cash) and decreases Equity (via Contra-Equity Treasury Stock).

• Cash Flow Statement: Financing Cash Outflow.

How is Treasury Stock accounted for when RE-ISSUED ABOVE re-acquisition cost?

• Journal Entry: Debit: Cash (Shares x Re-issue Price) Credit: Treasury Stock (Shares x Re-acquisition Cost) Credit: Paid-In Capital - Treasury (Excess)

Note: The credit is NOT a gain (never record gains/losses on own stock); it is part of Contributed Capital in Equity.

How is Treasury Stock accounted for when RE-ISSUED BELOW re-acquisition cost?

• Journal Entry: Debit: Cash (Shares x Re-issue Price) Debit: Paid-In Capital - Treasury (up to its existing credit balance) Debit: Retained Earnings (for any remaining deficit if Paid-In Capital - Treasury reaches zero) Credit: Treasury Stock (Shares x Re-acquisition Cost)

Key Point: Paid-In Capital - Treasury cannot have a debit balance.

What are the key characteristics of Cash Dividends?

• Must be declared by the Board of Directors (not legally required until declared).

• Paid out of net income, but NOT an expense (does not affect Net Income).

• Account Type: Contra-equity account (reduces Retained Earnings).

• Dividends are ONLY paid on OUTSTANDING shares (never on treasury stock).

What are the 3 important dates relating to dividends, and what entry is made on each?

• 1. Date of Declaration: Board approves dividend. Liability created.

  • Entry: Debit Dividends, Credit Dividends Payable.

2. Date of Record: Determines who receives the dividend.

   • Entry: NO ENTRY REQUIRED.

3. Date of Payment: Cash distributed to stockholders.

   • Entry: Debit Dividends Payable, Credit Cash.

What is Cumulative Preferred Stock and Dividends in Arrears?

• Cumulative Preferred Stock: Preferred stockholders must receive both current year dividends AND any unpaid prior year dividends before common stockholders get anything.

• Dividends in Arrears: Unpaid preferred dividends from prior years.

• Accounting Treatment: Dividends in arrears are NOT actual liabilities (not recorded on balance sheet), but MUST be disclosed in financial statement notes.

What is Return on Equity (ROE), how is it calculated, and how is it interpreted?

• Formula: Net Income / Average Equity (Average Equity = [Jan 1 Equity + Dec 31 Equity] / 2)

Interpretation: Measures profit earned per dollar of invested capital. (e.g., ROE of 15% means $0.15 of profit per $1.00 invested). Higher is better.

What is Earnings per Share (EPS), how is it calculated, and what does it measure?

Formula: (Net Income - Preferred Stock Dividends) / Number of Common Shares Outstanding

Interpretation: Measures net income associated with each individual share of common stock. Tells stockholders their claim on company earnings for the year. Higher is better.

What is the Price-Earnings (P/E) Ratio, how is it calculated, and why is it unique?

• Formula: Market Price per Share of Stock / Earnings per Share (EPS)

Interpretation: Measures investor expectations regarding growth potential and earnings stability. Higher P/E ratios reflect strong predicted future growth. Uniqueness: It compares a financial statement number (EPS) to a market value number (Market Price), rather than two accounting numbers.

What is the definition of Property, Plant, and Equipment (PPE)?

Long-term assets that have physical substance, such as Land, Buildings, and Equipment.

What is the historical cost concept for PPE, and what does it include?

Plant assets are recorded at cost, which equals the purchase price plus all expenditures necessary to get the asset ready for its intended use (e.g., sales tax, freight/shipping, installation, assembly, closing fees).

What does it mean to capitalize a cost?

Capitalization means recording a cost on the balance sheet as part of an asset's cost rather than as an immediate expense on the income statement.

How are recurring, ongoing costs (like maintenance, repairs, or insurance after an asset is in use) accounted for?

They are expensed immediately on the income statement as incurred (not capitalized).

How is the total acquisition cost allocated among individual assets acquired in a lump-sum purchase?

Cost is allocated based on each individual asset's percentage of the total market value.

What are capital expenditures, and how are they recorded?

Substantial, infrequent costs incurred to increase operating efficiency, productive capacity, or useful life; they are capitalized on the balance sheet by adding them to the asset account.

What are revenue expenditures, and how are they recorded?

Small, frequent costs incurred to maintain an asset in good working order (ordinary repairs); they are expensed immediately on the income statement as Repair Expense.

What is the definition and purpose of depreciation in financial accounting?

The systematic allocation of a plant asset's cost to expense over its useful life ("using up" the asset); required by the matching concept to align expenses with revenue generation.

Does depreciation reflect a decline in an asset's fair market value?

No, depreciation has nothing to do with asset market value.

Why is Land never depreciated?

Land does not depreciate because its usefulness and revenue-producing capability remain intact over time (it never gets "used up").

What is the general journal entry recorded annually for depreciation?

Debit: Depreciation Expense | Credit: Accumulated Depreciation.

What type of account is Accumulated Depreciation, and where does it appear?

A contra asset account with a normal credit balance, reported on the balance sheet directly below the asset being depreciated.

What is the formula for Book Value?

Book Value = Cost of Asset - Accumulated Depreciation

What impact does depreciation expense have on statement of cash flows?

None; depreciation is a non-cash expense.

What is the formula for annual Straight-Line Depreciation Expense?

Annual Depreciation Expense = (Cost - Residual Value) / Useful Life (in Years)

What must an asset's ending book value equal once it is fully depreciated?

Its residual (salvage) value.

How do you adjust straight-line depreciation if an asset is purchased during the year?

Multiply full-year depreciation by the fraction of the year owned: Months Owned / 12

What is Sum-of-the-Years'-Digits (SYD) depreciation?

An accelerated depreciation method that records more expense in the early years of an asset's life and less in later years.

What is the formula for SYD depreciation expense?

Depreciation expense = (Cost - Residual) x (Remaining Life / SYD)

How do you calculate the SYD denominator for a 5-year asset?

Sum the digits of the useful life: 5 + 4 + 3 + 2 + 1 = 15

What is the formula for Double-Declining Balance (DDB) annual depreciation expense?

Depreciation Expense = Beginning Book Value x (2 / Useful Life)

Is residual value subtracted when setting up the initial DDB annual depreciation calculation?

No, residual value is ignored in the rate calculation, but total depreciation must stop once ending book value hits residual value.

Do accelerated methods record more total depreciation over an asset's life than straight-line?

No, all depreciation methods record the exact same total depreciation expense over the life of the asset; it is strictly a timing issue.

In Year 1 of an asset's life, which method shows the highest Net Income?

Straight-Line (it records lower depreciation expense in Year 1 than accelerated methods).

In Year 1, which method gives an income tax advantage?

Accelerated Methods (higher initial expense reduces net income, minimizing tax payments).

In Year 1, which method shows the highest Total Assets on the balance sheet?

Straight-Line (lower accumulated depreciation results in a higher asset book value).

In the LAST year of an asset's life, which method shows higher depreciation expense?

Straight-Line (accelerated methods record higher expense upfront and lower expense in final years).

At the END of an asset's useful life, which method shows the highest Total Assets?

Both show the same total assets because total accumulated depreciation across the asset's full life is identical.

How does Units-of-Production (UOP) depreciation differ from time-based methods?

UOP is based on actual usage/activity (e.g., miles driven, units produced) rather than the passage of time.

What are the formulas for Units-of-Production depreciation?

1. Usage Rate = (Cost - Residual) / Total Estimated Usage

2. Depreciation Expense = Usage Rate x Actual Usage for Period

Why is there no partial-year time adjustment for UOP depreciation?

UOP is purely driven by physical asset usage, regardless of purchase date or length of ownership.

How are changes in useful life or residual value accounted for?

Prospectively—new estimates are applied to current and future years only; prior years' recorded depreciation is never adjusted.

What is the formula for annual depreciation after a change in estimate?

New Annual Depreciation = (Book value at change date - New Residual Value) / Remaining Useful Life

How does a capital expenditure (e.g., major overhaul extending life) impact future depreciation?

It is capitalized into book value (Cost + Capital Expenditure - Accumulated Depreciation), requiring a recalculation of future annual depreciation.

How does a revenue expenditure (ordinary repair) impact depreciation?

It doesn't. A revenue expenditure has no impact on depreciation.

How is a gain or loss on the sale of a plant asset determined?

Compare cash received to book value:

• Cash Received > Book Value: Gain on Sale

• Cash Received < Book Value: Loss on Sale.

What four steps/accounts must be included in the journal entry for an asset sale?

• Debit: Cash received

• Debit: Accumulated Depreciation (to eliminate related accumulated depreciation)

• Credit: Asset Account (at original historical cost to eliminate asset)

• Debit Loss OR Credit Gain.

Where are Gain on Sale and Loss on Sale reported on financial statements?

On the income statement (Gain is a revenue account that increases net income; Loss is an expense account that decreases net income).