Medium Practice Test

Introduction to Accounting

Medium Practice Test

Click the “Check Your Answer” box below each problem to reveal the correct answer and explanation.

1.  The objective of the equity method is to report the investment value at the

a.  investors share of the book value of the investee
b.  fair market value of the investment
c.  original cost of investment plus dividends received
d.  original cost of the investment plus losses generated by the company

Check Your Answer
A.  The objective of the equity method is to report the investment value at an amount equivalent to the % owned of the investee company’s owner’s equity.   The equity method does not report fair market value. Original cost is adjusted each period for dividends received (decreased) and profits (increased) or losses (decreased) and to eliminate the difference in book value and fair market value at the time of purchase.
2.  When using the equity method, the transaction that increases the investors income is

a.  receiving dividends
b.  profits earned by the investee
c.  losses earned by the investee 
d.  appreciation in market value

Check Your Answer
B.  Dividends are recorded with a decrease to the investment account and no revenue is recorded for dividends received.  The investors share of profits and losses is recorded. Profits increase the investment account and losses decrease the investment account.  Changes in fair market value are not recorded when using the equity method.
3.  An investor who owns less than 20% and receives dividends will report a(n)

a.  decrease to net income
b.  increase to unrealized holding gain – IS
c.  increase to other revenues
d. decrease to the investment value

Check Your Answer
C.  The fair market value method is used when there is less than 20% ownership.  Under the fair market value method, dividends are recorded as dividend revenue in the other revenues/expense section of the income statement.  Revenues increase net income.
4.  The amount reported on the income statement related to an equity or bond classified as a trading security will be

a.  dividends received plus the change in market value during the period
b.  the cumulative change in market value 
c.  the cumulative change in market value less dividends received
d.  the profits or losses of the company invested in

Check Your Answer
A.  The fair market value method is used to account for equities and bonds classified as trading securities.  Dividends are reported on the income statement as dividend revenue. Changes in fair market value are reported on the income statement as unrealized holding gain/loss, under other revenues/expenses.   The income statement only reports activity for the current period (b. & c.) The equity method reports the investors share of net income or loss.
5.  Held to maturity securities are

a.  bonds the investor intends to hold for more than one year
b.  equities that management intends to hold until maturity
c.  any security held for a minimum of one year
d.  bonds the investor intends to hold until the repayment date

Check Your Answer
D.  To qualify as a held to maturity security, the security must be a bond and management must intend to hold the bond to maturity.  Equity securities do not have a maturity (c.)
6.  An investor could report interest revenue from which of the following investments?

a.  held to maturity
b.  trading
c.  available for sale
d.  all of the above

Check Your Answer
D.  Interest revenue is earned from investing in bonds.  Bonds can be held in any of the listed categories of investments.  The classification is based on the length of time the investor intends to hold the bond.
7.  Selling a trading or equity security for more than the FMV at the end of the prior period will result in

a.  a debit to the unrealized holding gain/loss account
b.  a debit to the fair value adjustment account  
c.  both a. & b.
d.  an increase to the unrealized holding gain – OE account

Check Your Answer
B.  Selling an asset for more than last period’s FMV will result in an additional gain.  The fair value adjustment account increases with a debit and the unrealized holding G/L account is credited to report a gain. The unrealized holding gain/loss – OE account is used for available for sale securities.  
8. The method used to account for a publicly traded investment is dependant on

a.  the level of significant influence
b.  if the security is held long term or short term
c.  the amount paid for the investment
d.  the industry the investee operates in

Check Your Answer
A.  FASB gives two primary choices for accounting for investments: 1) fair market value method when there is no significant influence and 2) equity method when there is significant influence.   The other factors listed do not impact the method chosen; however, investments with significant influence are generally held long-term.
9.  Trading securities are always classified on the balance sheet as

a.  long-term investments
b.  current assets
c.  other assets
d.  tangible assets

Check Your Answer
B.  Trading securities by definition are held for one year or less.  Assets held for one year or less are reported as current assets.  
10.  Fair value of the investment and profitability of the investee are not relevant for which classification?

a.  trading
b.  available for sale
c.  held to maturity
d.  equity method securities

Check Your Answer
C.   Investors who intend to hold bonds to maturity are not concerned about the current fair market value.  Bonds carry no significant influence and therefore a share of profits is not reported for bonds. Trading and available for sale securities are adjusted to fair market value at the end of each period. 
11.  The company purchased the following stock with the intent to hold long term:

Old Corp. was purchased at a cost of $10 per share for 5,000 shares 
New Corp. was purchased at a cost of $25 per share for 10,000 shares

Fair market prices (bid ask quote) at the end of each year were:

End of 1st year End of 2nd year Dividends paid each year per share
Old $11 $15 $1
New $27 $22 $3

Determine the line items and amounts the company will report on the income statement and balance sheet given there is no significant influence.

Check Your Answer
Income Statement 1st Year 2nd Year
Old 5,000 20,000
New 20,000 (50,000)
25,000 (35,000) Unrealized Holding G/L
Old Dividend 5,000 5,000
New Dividend 30,000 30,000
35,000 35,000 Dividend Income
Balance Sheet- investment at fair market value:
Old 55,000 75,000
New 270,000 220,000
325,000 295,000 L/T Invesment


12.  A company (investor) recorded the following entries related to its investment in 10,000 shares of New, Co. common stock.  At the time of investment, New Co. owned a building that had a lower fair market value than book value with an estimated life of 30 years.  For the current year New Co. earned $200,000 in profits and the investor recorded.

L/T Investment                      60,000
         Investment Revenue              60,000

Cash                                             6,000
         L/T Investment                         6,000

L/T Investment                        3,000
         Investment Revenue                3,000

A.  What method was used to account for the investment
B.  What % ownership does the company own?
C.  What was the total dividend paid by the company?
D.  What was the difference in Book Value and Fair Market Value of the building at the time of purchase?  Was book value or fair market value higher?

Check Your Answer
A.  The equity method because the investor has significant influence. The adjustments are made to record the company’s share of profits, the company’s share of dividends, and to eliminate the difference in fair market value and book value.  The equity method records dividends as a reduction to the investment account.

B.  Look at the entry that records the share of profits and determine what % of total income was recorded.

$60,000  / $200,000  = 30% ownership
revenue      profits

C.  $6,000 recorded / 30% owned = $20,000 total dividend paid.

The company received 30% of total dividends paid because they owned 30% of the company

D.  The third entry represents the elimination of the difference in fair market value and book value on the date of purchase.

The formula for determining the amount is:

FMV – BV   x % purchased / useful life = amount eliminated annually

$ ??       x 30%   = $?? / 30 years = $3,000

$300,000 x 30% = $90,000 / 30 years = $3,000

The investment increased; therefore, the fair market value was lower than book value at the time of purchase.

13.  An investor holds the following securities at the end of the first year of operations:

Stocks Bonds (AFS) Equity 30% owned
Cost $50,000 $150,000 $500,000
Market $60,000 $120,000 $600,000
Total investee’s net income $100,000
Dividend’s received $3,000 $10,000
Interest received $4,000

A.  Record all journal entries related to the investments for the investor.

B.  What will the investor report on the balance sheet and income statement on December 31st of the first year of operations?  Give account names and amounts.

Check Your Answer
A.  Stocks held LT

Fair Value Adjustment                  10,000
         Unrealized Holding G/L – IS           10,000

Bonds held LT:

Unrealized Holding G/L – OE     30,000
         Fair Value Adjustment                    30,000


Cash                                               7,000
         Dividend Income                           3,000
         Interest Income                             4,000

Equity Method (30% owned gives significant influence):

Investment                                     30,000
         Investment Revenue                      30,000

($100,000 x 30%)

Cash                                               10,000
         Investment                                      10,000

(Total investee paid x 30%)

B.  Balance Sheet:

S/T Investments 60,000 at FMV
L/T Investments 120,000 FMV
L/T Equity Investments 520,000 (500,000 + 30,000 – 10,000)
Unrealized Holding G/L – OE (30,000) bonds only
Income Statement:
Unrealized Gain/(Loss) 10,000
Dividend Income 3,000
Interest Income 4,000
Investment Revenue 30,000

14.  At the beginning of year 1, the investor purchased 10,000 shares of common stock (10%) of Twilight, Inc. for $200,000.   The investor intends to hold the investment for 5 years. Information related to Twilight, Inc. for the first 2 years follow:

Year 1 Year 2
Net Income 100,000 150,000
Dividends Paid 5,000 6,000
FMV > BV (10 year life) 80,000
FMV of stock price 12/31 $22 $25

A.  Record the entries for the investment in Twilight, Inc. for year 1.
B.  Record the entries for the investment in Twilight, Inc. for year 2.
C.  State the accounts and amounts the investor will report on the balance sheet for year 2.

Check Your Answer
A.  Year 1:

Fair Value Adjustment                  20,000
       Unrealized Holding G/L – IS             20,000

Cash                                                   500
       Dividend Income                                  500
                   (10% x total dividends of $5,000)

B.  Year 2:

Fair Value Adjustment               30,000
       Unrealized Holding G/L – IS            30,000

Cash                                                   600
       Dividend Income                                  600     

(10% x total dividends of $6,000)

C.  Investor’s Financial Statements

Balance Sheet:

LT Investment $250,000   at FMV

Income Statement:

Unrealized Holding G/L    $30,000
Dividend Income               $     600