FAR SU 3

During all of the year just ended, Littlefield, Inc., had outstanding 100,000 shares of common stock and 5,000 shares of noncumulative, $7 preferred stock. Each share of the latter is convertible into three shares of common. For the year, Littlefield had $230,000 income from continuing operations and a $575,000 loss on discontinued operations; no dividends were paid or declared. Littlefield should report diluted earnings (loss) per share (DEPS) for income from continuing operations and for net income (loss), respectively, of A. $2.00 and $(3.00). B. $2.26 and $(3.39). C. $2.30 and $(3.45). D. $2.19 and $(3.29).

$2.00 and $(3.00). Answer (A) is correct. The noncumulative convertible preferred stock is dilutive because its assumed conversion will have no effect on the DEPS numerator and will increase the denominator by 15,000 (5,000 × 3) shares. DEPS for income from continuing operations is $2.00 ($230,000 ÷ 115,000 shares). Net loss equals the $230,000 income from continuing operations minus the $575,000 loss on discontinued operations, or $345,000. This amount divided by the 115,000 shares results in a diluted net loss per share of $3.00.

Collins Company reported net income of $350,000 for the year. The company had 10,000 shares of $100 par value, noncumulative, 6% preferred stock and 100,000 shares of $10 par value common stock outstanding. Also, 5,000 shares of common stock were in treasury during the year. Collins declared and paid all preferred dividends as well as a $1 per share dividend on common stock. Collins Company's basic earnings per share of common stock for the year was A. $3.50 B. $2.90 C. $3.33 D. $2.76

B. $2.90 Answer (B) is correct. The numerator for BEPS consists of income available to common shareholders (net income - noncumulative preferred dividends declared). For Collins, this amount is $290,000 [$350,000 - (10,000 shares × $100 par × 6%)]. The denominator consists of the weighted-average number of common shares outstanding. Because (1) no shares were issued during the year, (2) no splits occurred, and (3) treasury stock is not outstanding, the denominator is 100,000 shares. BEPS is therefore $2.90 ($290,000 ÷ 100,000).

Conn Co. reported a retained earnings balance of $400,000 at December 31, Year 2. In August Year 3, Conn determined that insurance premiums of $60,000 for the 3-year period beginning January 1, Year 2, had been paid and fully expensed in Year 2. Conn has a 30% income tax rate. What amount should Conn report as adjusted beginning retained earnings in its Year 3 statement of retained earnings? A. $442,000 B. $428,000 C. $440,000 D. $420,000

B. $428,000 Answer (B) is correct. Prior-period adjustments must be reflected net of applicable income taxes as changes in the opening balance in the statement of retained earnings. The $60,000 insurance prepayment in Year 2 should have been expensed ratably over the 3-year period. Consequently, Year 2 net income was understated by $40,000, net of tax effect, and $40,000 [$60,000 - ($60,000 ÷ 3)] should have been reported as a prepaid expense (an asset) at the beginning of Year 3. The prior-period adjustment to the beginning balance of retained earnings is therefore a credit of $28,000 [$40,000 × (1.0 - .30 tax rate)]. The adjusted balance is $428,000 ($400,000 + $28,000).

A firm has basic earnings per share of $1.29. If the tax rate is 30%, which of the following securities would be dilutive? A. Seven percent convertible bonds, issued at par, with each $1,000 bond convertible into 40 shares of common stock. B. Cumulative 8%, $50 par preferred stock. C. Ten percent convertible bonds, issued at par, with each $1,000 bond convertible into 20 shares of common stock. D. Six percent, $100 par cumulative convertible preferred stock, issued at par, with each preferred share convertible into four shares of common stock.

B. Cumulative 8%, $50 par preferred stock. *Answer (B) is incorrect.* Unless the preferred stock is convertible, it is not dilutive. Nonconvertible preferred shares are not potential common stock and therefore are not considered in the calculation of DEPS. C. Ten percent convertible bonds, issued at par, with each $1,000 bond convertible into 20 shares of common stock. *Answer (C) is incorrect.* The conversion of the bonds would eliminate after-tax interest expense per bond of $70 [($1,000 par × 10%) × (1.0 - 30% tax rate)]. (The bonds were issued at par, so amortization of premium or discount does not affect the calculation.) The per-share effect is $3.50 ($70 ÷ 20 shares per bond). Thus, the convertible debt is antidilutive ($3.50 > $1.29 BEPS). D. Six percent, $100 par cumulative convertible preferred stock, issued at par, with each preferred share convertible into four shares of common stock. *Answer (D) is incorrect.* If the preferred stock is converted, the EPS numerator increases by the dividend savings of $6 ($100 par × 6%) per share of preferred stock (the additional income available to common shareholders). The per-share effect is $1.50 ($6 ÷ 4 common shares per share of preferred stock). Thus, the preferred stock is antidilutive ($1.50 > $1.29 BEPS). A. Seven percent convertible bonds, issued at par, with each $1,000 bond convertible into 40 shares of common stock. Answer (A) is correct. The calculation of dilutive EPS (DEPS) gives effect to dilutive potential common shares (e.g., options and convertible securities). Dilution is a reduction in basic EPS (BEPS) resulting from the assumption that (1) convertible securities were converted, (2) options or warrants were exercised, or (3) contingently issuable shares were issued. The conversion of the bonds would eliminate after-tax interest expense per bond of $49 [($1,000 par × 7%) × (1.0 - 30% tax rate)]. (The bonds were issued at par, so amortization of premium or discount does not affect the calculation.) The per-share effect is $1.225 ($49 ÷ 40 shares per bond). Thus, the convertible debt is dilutive ($1.225 < $1.29 BEPS).

Under IFRS, changes in accounting estimates are viewed as A. Errors in reported amounts in prior periods. B. Reassessments of current status and future benefits and obligations. C. Catch-up adjustments related to amounts reported in prior periods. D. Items of other comprehensive income.

B. Reassessments of current status and future benefits and obligations. Answer (B) is correct. A change in accounting estimate adjusts the carrying amount of an asset or liability or the consumption of an asset. It results from reassessing the status and expected benefits and obligations related to assets and liabilities. It is based on new information or new developments and is not an error correction.

Fact Pattern: Peters Corp.'s capital structure was as follows: December 31 Year 7 Year 8 Outstanding shares of stock: Common 100,000 100,000 Convertible preferred 10,000 10,000 9% convertible bonds $1,000,000 $1,000,000 During Year 8, Peters paid dividends of $3.00 per share on its preferred stock. The preferred shares are convertible into 20,000 shares of common stock, and the 9% bonds are convertible into 30,000 shares of common stock. Assume that the income tax rate is 30%. If net income for Year 8 is $245,000, Peters should report DEPS as A. $2.05 B. $2.15 C. $2.04 D. $2.14

C. $2.04 Answer (C) is correct. Potential common stock is included in the calculation of DEPS if it is dilutive. When two or more issues of potential common stock are outstanding, each issue is considered separately in sequence from the most to the least dilutive. This procedure is necessary because a convertible security may be dilutive on its own but antidilutive when included with other potential common shares in the calculation of DEPS. The incremental effect on EPS determines the degree of dilution. The lower the incremental effect, the more dilutive. The incremental effect of the convertible preferred stock is $1.50 [($3 preferred dividend × 10,000) ÷ 20,000 potential common shares]. The numerator effect of the conversion of the bonds is $63,000 [$1,000,000 × 9% × (1.0 - .30 tax rate)]. The incremental effect of the convertible debt is $2.10 ($63,000 ÷ 30,000 potential common shares). The $1.50 incremental effect of the convertible preferred stock is lower than BEPS, so it is dilutive and should be included in a trial calculation of DEPS. The result is $2.04 [($245,000 - $30,000 + $30,000) ÷ (100,000 + 20,000)]. *Because the $2.10 incremental effect of the convertible debt is higher than $2.04, the convertible debt is antidilutive* and should not be included in the DEPS calculation. Thus, DEPS should be reported as $2.04.

act Pattern: Peters Corp.'s capital structure was as follows: December 31 Year 7 Year 8 Outstanding shares of stock: Common 100,000 100,000 Convertible preferred 10,000 10,000 9% convertible bonds $1,000,000 $1,000,000 During Year 8, Peters paid dividends of $3.00 per share on its preferred stock. The preferred shares are convertible into 20,000 shares of common stock, and the 9% bonds are convertible into 30,000 shares of common stock. Assume that the income tax rate is 30%. If net income for Year 8 is $245,000, Peters should report DEPS as A. $2.05 B. $2.15 C. $2.04 D. $2.14

C. $2.04 Answer (C) is correct. Potential common stock is included in the calculation of DEPS if it is dilutive. When two or more issues of potential common stock are outstanding, each issue is considered separately in sequence from the most to the least dilutive. This procedure is necessary because a convertible security may be dilutive on its own but antidilutive when included with other potential common shares in the calculation of DEPS. The incremental effect on EPS determines the degree of dilution. The lower the incremental effect, the more dilutive. The incremental effect of the convertible preferred stock is $1.50 [($3 preferred dividend × 10,000) ÷ 20,000 potential common shares]. The numerator effect of the conversion of the bonds is $63,000 [$1,000,000 × 9% × (1.0 - .30 tax rate)]. The incremental effect of the convertible debt is $2.10 ($63,000 ÷ 30,000 potential common shares). The $1.50 incremental effect of the convertible preferred stock is lower than BEPS, so it is dilutive and should be included in a trial calculation of DEPS. The result is $2.04 [($245,000 - $30,000 + $30,000) ÷ (100,000 + 20,000)]. Because the $2.10 incremental effect of the convertible debt is higher than $2.04, the convertible debt is antidilutive and should not be included in the DEPS calculation. Thus, DEPS should be reported as $2.04.

On July 1, Year 1, Rey Corp. purchased computer equipment at a cost of $360,000. This equipment was estimated to have a 6-year life with no residual value and was depreciated by the straight-line method. On January 3, Year 4, Rey determined that this equipment could no longer process data efficiently, that its value had been permanently impaired, and that $70,000 could be recovered over the remaining useful life of the equipment. What carrying amount should Rey report on its December 31, Year 4, balance sheet for this equipment? A. $150,000 B. $0 C. $50,000 D. $70,000

C. $50,000 Answer (C) is correct. At 1/3/Year 4, the carrying amount of the computer equipment should be written down to $70,000. This $70,000 is expected to be recovered over the 3.5-year remaining useful life of the equipment. Under the straight-line method, the depreciation expense for the year ending 12/31/Year 4 is $20,000 [($70,000 ÷ 42 months) × 12 months]. Thus, the carrying amount in the year-end balance sheet should be $50,000 ($70,000 - $20,000).

On January 2, Year 4, Raft Corp. discovered that it had incorrectly expensed a $210,000 machine purchased on January 2, Year 1. Raft estimated the machine's original useful life to be 10 years and its salvage value at $10,000. Raft uses the straight-line method of depreciation and is subject to a 30% tax rate. In its December 31, Year 4, financial statements, what amount should Raft report as a prior period adjustment? A. $165,900 B. $102,900 C. $168,000 D. $105,000

D. $105,000 Answer (D) is correct. Expensing the machine in Year 1 resulted in an after-tax understatement of net income equal to $147,000 [$210,000 × (1.0 - .30 tax rate)]. Not recognizing annual depreciation of $20,000 [($210,000 - $10,000 salvage value) ÷ 10 years] in Years 1 - 3 resulted in an after-tax overstatement of net income equal to $42,000 [($20,000 × 3 years) × (1.0 - .30 tax rate)]. Thus, the prior period adjustment is for a net understatement of $105,000 ($147,000 - $42,000).

Fact Pattern: Loire Co. has used the FIFO method since it began operations in Year 3. Loire changed to the weighted-average method for inventory measurement at the beginning of Year 6. This change was justified. In its Year 6 financial statements, Loire included comparative statements for Year 5 and Year 4. The following shows year-end inventory balances under the FIFO and weighted-average methods: Year FIFO Weighted-Average 3 $ 90,000 $108,000 4 156,000 142,000 5 166,000 150,000 By what amount should Loire's cost of sales be retrospectively adjusted for the year ended December 31, Year 5?

D. $2,000 increase. Answer (D) is correct. Retrospective application requires that all periods reported be individually adjusted for the period-specific effects of applying the new principle. Cost of sales equals beginning inventory, plus purchases, minus ending inventory. Purchases are the same under FIFO and weighted average. Thus, the retrospective adjustment to cost of sales equals the change in beginning inventory resulting from the change from FIFO to weighted average minus the change in ending inventory. This adjustment equals an increase in cost of sales of $2,000 [($156,000 - $142,000) - ($166,000 - $150,000)].

The following information pertains to Maynard Corporation's income statement for the 12 months just ended. The company has an effective income tax rate of 40%. Loss on discontinued operations $(70,000) Error in the previous year's income statement discovered during the current period (90,000) Income from continuing operations (net of tax) 72,000 Cumulative effect of change in accounting principle 60,000 Maynard's net income for the year is A. $44,000 B. $36,000 C. $2,000 D. $30,000

D. $30,000 Answer (D) is correct. The cumulative effect of a change in accounting principle and prior-period errors have no effect on current-period income. They must be accounted for retrospectively. Retrospective application requires the beginning balance of retained earnings to be adjusted for the cumulative effect of (1) applying a new principle and (2) errors on the prior-period income statements. Maynard's net income for the year is calculated as follows:

During the current year, Comma Co. had outstanding: 25,000 shares of common stock; 8,000 shares of $20 par, 10% cumulative preferred stock; and 3,000 bonds that are $1,000 par and 9% convertible. The bonds were originally issued at par, and each bond was convertible into 10 shares of common stock. During the year, net income was $200,000, no dividends were declared, and the tax rate was 30%. What amount was Comma's basic earnings per share for the current year? A. $7.07 B. $8.00 C. $6.78 D. $7.36

D. $7.36 Answer (D) is correct. The numerator of the basic earnings per share (BEPS) ratio is income available to common shareholders. Declared dividends and accumulated dividends on preferred stock are removed from net income for the period to arrive at this amount. The undeclared but cumulative dividends on preferred stock equal $16,000 (8,000 shares × $20 par × 10%). Thus, given no dividends declared, the income available to common shareholders is $184,000 ($200,000 - $16,000). This amount is divided by the weighted-average common shares outstanding. All 25,000 of the common shares were outstanding during the entire period. Accordingly, BEPS equals $7.36 ($184,000 ÷ 25,000 shares).

Tone Company is the defendant in a lawsuit filed by Witt in Year 2 disputing the validity of a copyright held by Tone. At December 31, Year 2, Tone determined that Witt would probably be successful against Tone for an estimated amount of $400,000. Appropriately, a $400,000 loss was accrued by a charge to income for the year ended December 31, Year 2. On December 15, Year 3, Tone and Witt agreed to a settlement providing for a cash payment of $250,000 by Tone to Witt, and the transfer of Tone's copyright to Witt. The carrying amount of the copyright on Tone's accounting records was $60,000 at December 15, Year 3. What would be the effect of the settlement on Tone's income before income tax in Year 3? A. $150,000 increase. B. No effect. C. $60,000 decrease. D. $90,000 increase.

D. $90,000 increase. Answer (D) is correct. In Year 2, a $400,000 contingent loss and an accrued liability in the amount of $400,000 were properly recognized. In Year 3, the actual loss of $310,000 ($250,000 cash + $60,000 carrying amount of the copyright) was $90,000 less than the previously estimated amount. This new information should be treated as a change in estimate and accounted for in the period of change. Consequently, the $90,000 difference will be credited to Year 3 income as a recovery of a previously recognized loss.

The following information is relevant to the computation of Chan Co.'s earnings per share to be disclosed on Chan's income statement for the year ending December 31: Net income for the year is $600,000. $5,000,000 face amount 10-year convertible bonds outstanding on January 1. The bonds were issued four years ago at a discount that is being amortized in the amount of $20,000 per year. The stated rate of interest on the bonds is 9%, and the bonds were issued to yield 10%. Each $1,000 bond is convertible into 20 shares of Chan's common stock. Chan's corporate income tax rate is 25%. Chan has no preferred stock outstanding and no other convertible securities. What amount should be used as the numerator in the fraction used to compute Chan's diluted earnings per share, assuming that the bonds are dilutive securities? A. $130,000 B. $247,500 C. $1,070,000 D. $952,500

D. $952,500 Answer (D) is correct. To determine the DEPS numerator, the BEPS numerator (income available to common shareholders) is adjusted. Amounts are added back to the BEPS numerator for any dividends on convertible preferred stock and the after-tax interest (after amortization of discount or premium) related to any convertible debt. The numerator also is adjusted for other changes in income or loss, such as profit-sharing expenses, that would result from the assumed issuance of PCS. Income available to common shareholders is $600,000 because the entity has no preferred stock. Thus, the only adjustment is for after-tax interest (after discount amortization) related to the bonds. Accordingly, the DEPS numerator is $952,500 {$600,000 NI + [($5,000,000 × 9%) interest paid + $20,000 discount amortized] × 1.0 - .25 tax rate}. NOTE: The question calls for discount amortization using the straight-line method instead of the effective interest method. The second method is required by U.S. GAAP unless the results of the two methods do not differ materially.

Ray Company has 530,000 common shares outstanding at year end. At December 31, for basic-earnings-per-share purposes, Ray computed its weighted, average number of shares as 500,000. Prior to issuing its annual financial statements, but after year end, Ray split its stock 2 for 1. Ray's weighted-average number of shares to be used for computing annual basic earnings per share is A. 500,000 B. 1,060,000 C. 530,000 D. 1,000,000

D. 1,000,000 Answer (D) is correct. The number of common shares outstanding for BEPS purposes must be weighted for stock splits and dividends, no matter when they are declared and distributed. Thus, the weighted-average number of shares is 1,000,000 (500,000 × 2).