Intermediate Financial Accounting III Exam
Intermediate Financial Accounting III Exam covers advanced financial reporting topics, including dilutive securities, earnings per share (EPS), investments, revenue recognition, income taxes, leases, accounting changes, and the statement of cash flows. EPS calculations differentiate between basic and diluted EPS, considering stock options, convertible securities, and warrants. Investments are classified as trading, available-for-sale, or held-to-maturity, impacting financial statements differently. Revenue recognition follows ASC 606, emphasizing performance obligations and timing of revenue. Deferred tax assets and liabilities arise from temporary differences in tax and book income. Leases are categorized as finance or operating under ASC 842, affecting financial statements differently. Accounting changes, including principle changes and error corrections, require retrospective or prospective application. The statement of cash flows classifies activities into operating, investing, and financing, providing insight into a company’s liquidity and financial health. Mastering these concepts ensures a solid understanding of complex financial accounting principles.
Sample Questions and Answers
Which of the following is true about temporary differences in accounting for income taxes?
A) They only affect the current tax expense
B) They result in deferred tax assets or liabilities
C) They are recorded directly in equity
D) They have no impact on taxable income
Answer: B
Explanation: Temporary differences create deferred tax assets or liabilities because they lead to differences in taxable income and accounting income in future periods.
A finance lease (formerly capital lease) should be recorded as an asset and liability when which condition is met?
A) The lease term is longer than one year
B) The lease agreement is cancellable
C) The lessee effectively obtains control of the asset
D) The lease involves only a small portion of the lessee’s operations
Answer: C
Explanation: If a lessee obtains control of the asset, the lease is classified as a finance lease and recorded as both an asset and a liability.
Which of the following is NOT a method of accounting for changes in accounting estimates?
A) Retrospective adjustment
B) Prospective application
C) Restating prior financial statements
D) Disclosure in the footnotes only
Answer: A
Explanation: Changes in accounting estimates are applied prospectively, meaning prior periods are not restated.
Which type of cash flow is the purchase of equipment classified under in the statement of cash flows?
A) Operating activities
B) Investing activities
C) Financing activities
D) Non-cash activities
Answer: B
Explanation: The purchase of equipment is considered an investing activity because it involves the acquisition of long-term assets.
Under the direct method of preparing the statement of cash flows, which of the following would be included in cash flows from operating activities?
A) Depreciation expense
B) Payment to suppliers
C) Issuance of common stock
D) Purchase of land
Answer: B
Explanation: The direct method presents actual cash payments and receipts, and payments to suppliers are included in operating activities.
Which of the following is a condition for recognizing revenue over time rather than at a point in time?
A) The customer receives a product in a single delivery
B) The seller has an enforceable right to payment for performance completed to date
C) The contract contains only one performance obligation
D) The transaction price is variable
Answer: B
Explanation: If a seller has a right to payment for work completed and the customer benefits from the service as it is performed, revenue is recognized over time.
Which of the following statements is true regarding basic earnings per share (EPS) calculation?
A) Preferred stock dividends are ignored
B) Stock splits are only considered if they occur before year-end
C) The weighted-average number of shares outstanding is used
D) Treasury stock increases the denominator
Answer: C
Explanation: EPS is calculated by dividing net income available to common shareholders by the weighted-average number of common shares outstanding during the period.
Which of the following securities is most likely to be anti-dilutive when computing diluted EPS?
A) Convertible bonds
B) Stock options with an exercise price below the market price
C) Preferred stock with a conversion feature
D) Stock warrants with an exercise price above the market price
Answer: D
Explanation: If the exercise price of stock warrants is higher than the market price, they are unlikely to be exercised, making them anti-dilutive.
How should an investor report a 30% ownership in another company when they have significant influence?
A) Fair value method
B) Equity method
C) Consolidation method
D) Cost method
Answer: B
Explanation: The equity method is used when an investor has significant influence, usually indicated by ownership of 20%-50% of voting shares.
Which of the following represents a permanent difference in accounting for income taxes?
A) Depreciation differences between tax and financial reporting
B) Accrued warranty costs
C) Municipal bond interest income
D) Temporary differences from installment sales
Answer: C
Explanation: Municipal bond interest is never taxable, making it a permanent difference.
Which lease classification results in recognizing interest expense and amortization expense separately?
A) Operating lease
B) Finance lease
C) Sale-leaseback transaction
D) Short-term lease
Answer: B
Explanation: Under a finance lease, the lessee recognizes both interest expense on the lease liability and amortization expense on the right-of-use asset.
Which of the following is NOT an acceptable method for accounting for changes in accounting principles?
A) Retrospective adjustment
B) Prospective application
C) Restating prior periods
D) Immediate expensing of the change
Answer: D
Explanation: Changes in accounting principles must be applied retrospectively or restated if necessary, but they cannot be expensed immediately.
When a company discovers an accounting error from a prior year, how should it be reported?
A) As an expense in the current period
B) As a correction in retained earnings
C) As an adjustment to the current period’s revenue
D) As a note disclosure only
Answer: B
Explanation: Prior period errors are corrected by adjusting the beginning retained earnings balance in the earliest comparative period presented.
A lessee should classify a lease as a finance lease if which condition is met?
A) The lease term is less than 12 months
B) The asset is returned to the lessor at the end of the lease
C) The lessee gains control of the asset and has the right to substantially all of its benefits
D) The lease contains only variable payments
Answer: C
Explanation: If the lessee gains control and substantially all benefits of the asset, the lease is classified as a finance lease.
Under the indirect method of preparing the statement of cash flows, which of the following adjustments is made to net income?
A) Adding back depreciation expense
B) Subtracting accounts payable increase
C) Adding stock dividend distributions
D) Deducting proceeds from issuing common stock
Answer: A
Explanation: Depreciation is a non-cash expense and must be added back to net income when using the indirect method.
Which of the following is classified as a financing activity on the statement of cash flows?
A) Purchase of inventory
B) Issuance of bonds payable
C) Payment of interest expense
D) Sale of equipment
Answer: B
Explanation: Issuing bonds is a financing activity because it involves obtaining funds from creditors.
When should a company recognize revenue for a bill-and-hold arrangement?
A) When the product is shipped
B) When the contract is signed
C) When the customer takes control of the goods
D) At the end of the reporting period
Answer: C
Explanation: Revenue is recognized when the customer obtains control of the goods, even if they remain in the seller’s possession.
A company estimates that a lawsuit will likely result in a $500,000 loss. How should this be reported?
A) As a note disclosure only
B) As an expense in the period the lawsuit is settled
C) As a liability if the amount is reasonably estimable
D) As a prior period adjustment
Answer: C
Explanation: If a loss is probable and estimable, it should be recorded as a liability in the financial statements.
If an investor owns 10% of another company’s voting stock and lacks significant influence, which accounting method should be used?
A) Cost method or fair value method
B) Equity method
C) Consolidation
D) Proportional consolidation
Answer: A
Explanation: The fair value or cost method is used when the investor lacks significant influence.
Deferred tax assets arise when:
A) Taxable income is greater than accounting income
B) Taxable income is less than accounting income due to temporary differences
C) The company pays more taxes than required
D) Permanent differences occur
Answer: B
Explanation: Deferred tax assets result when taxable income is lower than accounting income due to temporary timing differences.
Which of the following is NOT a category under the fair value hierarchy?
A) Level 1
B) Level 2
C) Level 3
D) Level 4
Answer: D
Explanation: The fair value hierarchy consists of Level 1 (quoted market prices), Level 2 (observable inputs), and Level 3 (unobservable inputs).
Which of the following transactions would be classified as an investing activity?
A) Issuance of stock
B) Payment of dividends
C) Sale of a building
D) Purchase of inventory
Answer: C
Explanation: The sale of long-term assets is classified as an investing activity.
What happens to diluted EPS if a convertible bond is determined to be anti-dilutive?
A) It is included in the diluted EPS calculation
B) It is excluded from the diluted EPS calculation
C) It increases the number of shares outstanding
D) It decreases net income
Answer: B
Explanation: Anti-dilutive securities are excluded from diluted EPS because they would increase EPS instead of decreasing it.
Which of the following is an example of a cash equivalent?
A) 90-day Treasury bill
B) Accounts receivable
C) Common stock investments
D) Prepaid expenses
Answer: A
Explanation: A 90-day Treasury bill qualifies as a cash equivalent because it is a short-term, highly liquid investment.
A company recognizes a change in depreciation method. How is this accounted for?
A) As a retrospective adjustment
B) As a prospective change
C) By restating prior financial statements
D) As an error correction
Answer: B
Explanation: Changes in depreciation methods are treated as changes in estimates and applied prospectively.
Which of the following is NOT considered a component of stockholders’ equity?
A) Retained earnings
B) Common stock
C) Bonds payable
D) Additional paid-in capital
Answer: C
Explanation: Bonds payable is a liability, not part of stockholders’ equity.
When calculating diluted earnings per share, which of the following adjustments is made to net income?
A) Preferred dividends are added back
B) Interest expense on convertible debt is added back (net of tax)
C) Stock options are subtracted from net income
D) Treasury stock purchases are added back
Answer: B
Explanation: Interest on convertible debt is added back to net income when computing diluted EPS because the assumption is that the bonds are converted into common stock.
Which of the following is considered an equity security?
A) Treasury bonds
B) Convertible preferred stock
C) Commercial paper
D) Treasury bills
Answer: B
Explanation: Convertible preferred stock is an equity security because it represents ownership in a company and may be converted into common stock.
Under the percentage-of-completion method, how is revenue recognized?
A) Only when the project is completed
B) Based on progress toward completion
C) When cash is received
D) When the customer makes a final payment
Answer: B
Explanation: The percentage-of-completion method recognizes revenue based on the extent of work completed, ensuring revenue is reported progressively.
A deferred tax liability arises when:
A) Taxable income is lower than accounting income
B) Taxable income is higher than accounting income
C) A company pays more taxes than required
D) Permanent differences exist
Answer: A
Explanation: A deferred tax liability occurs when taxable income is lower than accounting income due to temporary differences, leading to higher future taxable amounts.
Which lease classification allows the lessee to report a right-of-use asset?
A) Finance lease
B) Operating lease
C) Capital lease
D) Short-term lease
Answer: A
Explanation: Under ASC 842, a finance lease requires the lessee to recognize a right-of-use asset and a lease liability on the balance sheet.
Which of the following represents a change in accounting principle?
A) Switching from straight-line depreciation to double-declining balance
B) Revising an estimate for bad debt expense
C) Changing from FIFO to LIFO inventory method
D) Correcting an error in financial statements
Answer: C
Explanation: A change in inventory valuation method is a change in accounting principle, requiring retrospective application unless impractical.
Which of the following is considered a financing activity in the statement of cash flows?
A) Issuing common stock
B) Paying accounts payable
C) Purchasing inventory
D) Collecting accounts receivable
Answer: A
Explanation: Issuing common stock is a financing activity because it involves raising capital from investors.
Which of the following transactions results in an increase in cash flows from financing activities?
A) Repurchase of treasury stock
B) Issuance of bonds payable
C) Payment of dividends
D) Purchase of equipment
Answer: B
Explanation: Issuance of bonds payable provides cash to the company, making it a financing activity.
How should a lessee report a short-term lease (less than 12 months) under ASC 842?
A) Recognize an asset and liability
B) Expense lease payments as incurred
C) Capitalize the lease obligation
D) Recognize a finance lease asset
Answer: B
Explanation: Short-term leases are expensed as incurred and do not require a right-of-use asset or lease liability.
Which of the following items is classified as a temporary difference in accounting for income taxes?
A) Fines and penalties
B) Municipal bond interest
C) Depreciation differences between tax and GAAP reporting
D) Dividends received deduction
Answer: C
Explanation: Depreciation differences create temporary tax differences because they reverse over time.
What is the effect of stock dividends on retained earnings?
A) Increases retained earnings
B) Decreases retained earnings
C) No effect on retained earnings
D) Converts retained earnings to cash
Answer: B
Explanation: Stock dividends reduce retained earnings and increase common stock and additional paid-in capital.
Which financial statement reflects changes in cash and cash equivalents?
A) Balance sheet
B) Income statement
C) Statement of cash flows
D) Statement of retained earnings
Answer: C
Explanation: The statement of cash flows reports changes in cash and cash equivalents over a period.
Which of the following is a required disclosure for changes in accounting principle?
A) Description of the change
B) Cumulative effect on prior years
C) Justification for the change
D) All of the above
Answer: D
Explanation: Companies must disclose the nature, impact, and justification for changes in accounting principles.
What is the primary objective of the statement of cash flows?
A) Report cash dividends paid
B) Provide information on a company’s cash receipts and payments
C) Show financial position at a point in time
D) Report profit or loss for the year
Answer: B
Explanation: The statement of cash flows details cash inflows and outflows from operating, investing, and financing activities.
Which of the following is a cash outflow from operating activities?
A) Repayment of debt
B) Purchase of land
C) Payment to suppliers
D) Issuance of common stock
Answer: C
Explanation: Payments to suppliers are part of normal business operations and classified under operating activities.
Which method of accounting for long-term construction contracts recognizes revenue before completion?
A) Completed-contract method
B) Percentage-of-completion method
C) Direct write-off method
D) Cash basis accounting
Answer: B
Explanation: The percentage-of-completion method recognizes revenue as work progresses.
Which statement is true about basic and diluted EPS?
A) Basic EPS is always lower than diluted EPS
B) Diluted EPS is calculated using only common shares outstanding
C) Basic EPS ignores potential common shares
D) Stock options decrease basic EPS
Answer: C
Explanation: Basic EPS does not consider potential common shares like convertible securities or stock options.
Which of the following is NOT included in operating cash flows under the indirect method?
A) Depreciation expense
B) Gain on sale of equipment
C) Increase in accounts receivable
D) Proceeds from bond issuance
Answer: D
Explanation: Proceeds from bond issuance are a financing activity, not an operating activity.
Which of the following is a potential dilutive security?
A) Accounts payable
B) Preferred stock with mandatory redemption
C) Convertible bonds
D) Trade receivables
Answer: C
Explanation: Convertible bonds can be converted into common stock, making them dilutive.
Which of the following is an example of a permanent tax difference?
A) Depreciation method differences
B) Accrued liabilities
C) Tax-exempt interest income
D) Net operating loss carryforwards
Answer: C
Explanation: Tax-exempt interest income never affects taxable income, making it a permanent difference.