Computational Problems

RECEIVABLE FINANCING ( PLEDGE, FACTORING, ASSIGNMENT)
NOTES RECEIVABLE (PROBLEMS)
LOANS RECEIVABLE (PROBLEMS)
COMPUTATIONAL- IDENTIFICATION
PROBLEM NO. 2
Your audit of Banayoyo Corporation for the year ended December 31, 2006 revealed that the Accounts Receivable
account consists of the following:
Trade accounts receivable (current) P3,440,00

0
Past due trade accounts 640,000
Uncollectible accounts 128,000
Credit balances in customers’ accounts (80,000)
Notes receivable dishonored 240,000
Consignment shipments – at cost
The consignee sold goods costing P96,000 for P160,000. A 10% commission
was charged by the consignee and remitted the balance to Banayoyo. The
cash was received in January, 2007. 320,000
Total P4,688,00
0
The balance of the allowance for doubtful accounts before audit adjustment is a credit of P80,000. It is estimated that
an allowance should be maintained to equal 5% of trade receivables, net of amount due from the consignee who is
bonded. The company has not provided yet for the 2006 bad debt expense.
Questions:
Based on the above and the result of your audit, determine the adjusted balance of following:
1. Trade accounts receivable
a. P4,080,000 c. P4,464,000
b. P3,440,000 d. P3,584,000
2. Allowance for doubtful accounts
a. P204,000 c. P172,000
b. P216,000 d. P179,200
3. Doubtful accounts expense
a. P264,000 c. P252,000
b. P220,000 d. P227,200
Suggested Solution:
Question No. 1
Trade receivables (current) P3,440,000
Past due trade accounts 640,000
Notes receivable dishonored 240,000
Consignment goods already sold (P160,000 x 90%) 144,000

Adjusted trade receivables P4,464,000
Question No. 2
Adjusted trade receivables P4,464,000
Less due from consignee 144,000
Basis of allowance for doubtful accounts 4,320,000
Bad debt rate 5%

Required allowance for doubtful accounts P 216,000
Question No. 3
Required allowance for doubtful accounts P216,000
Add write-off of uncollectible accounts 128,000
Total 344,000 Less allowance account before adjustment 80,000
Doubtful accounts expense P264,000
Answers: 1) C; 2) B; 3) A
PROBLEM NO. 3
Presented below are a series of unrelated situations. Answer the following questions relating to each of the
independent situations as requested.
1. Bantay Company’s unadjusted trial balance at December 31, 2006, included the following accounts:
Debit Credit
Accounts receivable P1,000,000
Allowance for doubtful accounts 40,000
Sales P15,000,00
0
Sales returns and allowances 700,000
Bantay Company estimates its bad debt expense to be 1 1/2% of net sales. Determine its bad debt expense for
2006.
a. P225,000 c. P214,500
b. P254,500 d. P 55,000
2. An analysis and aging of Burgos Corp. accounts receivable at December 31, 2006, disclosed the following:
Amounts estimated to be uncollectible P 1,800,000
Accounts receivable 17,500,000
Allowance for doubtful accounts (per books) 1,250,000
What is the net realizable value of Burgos’ receivables at December 31, 2006?
a. P15,700,000 c. P16,250,000
b. P17,500,000 d. P14,450,000
3. Cabugao Company provides for doubtful accounts based 3% of credit sales. The following data are available for
2006.
Credit sales during 2006 P21,000,000
Allowance for doubtful accounts 1/1/06 170,000
Collection of accounts written off in prior years (Customer credit was reestablished) 80,000
Customer accounts written off as uncollectible during 2006 300,000
What is the balance in allowance for doubtful accounts at December 31, 2006?
a. P630,000 c. P500,000
b. P420,000 d. P580,000
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4. At the end of its first year of operations, December 31, 2006, Caoayan, Inc. reported the following information:
Accounts receivable, net of allowance for doubtful accounts P9,500,000

Customer accounts written off as uncollectible during 2006 240,000
Bad debts expense for 2006 840,000
What should be the balance in accounts receivable at December 31, 2006, before subtracting the allowance for
doubtful accounts?
a. P10,100,000 c. P 9,740,000
b. P10,340,000 d. P10,580,000
5. The following accounts were taken from Cervantes Inc.’s balance sheet at December 31, 2006.
Debit Credit Accounts receivable P4,100,000
Net credit sales P7,500,000
If doubtful accounts are 3% of accounts receivable, determine the bad debt expense to be reported for 2006.
a. P123,000 c. P223,000
b. P 23,000 d. P225,000
Suggested Solution:
Question No. 1
Sales P15,000,000
Less sales returns and allowances 700,000
Net sales 14,300,000 Multiply by bad debt rate 1 1/2%
Bad debt expense P 214,500

Question No. 2
Amount estimated to be uncollectible (1,800,000)
Net realizable value P15,700,000

Question No. 3
Allowance for doubtful accounts 1/1/06 P170,00

0
Establishment of accounts written off in prior years 80,000
Customer accounts written off in 2006 (300,00
0)
Bad debt expense for 2006 (P21,000,000 X 3%) 630,000
Allowance for doubtful accounts 12/31/06 P580,00
0
Question No. 4
Bad debt expense for 2006 P840,000

Customer accounts written off as uncollectible during
2006 (240,000)
Allowance for doubtful accounts, 12/31/06 P600,000
30
Accounts receivable, net of allowance for doubtful
accounts P 9,500,000
Allowance for doubtful accounts, 12/31/06 600,000
Accounts receivable, before deducting allowance for
doubtful accounts P10,100,000
Question No. 5

Percentage 3%
Bad debt expense, before adjustment 123,000
Allowance for doubtful accounts (debit balance) 100,000
Bad debt expense for 2006 P 223,000
Answers: 1) C; 2) A; 3) D; 4) A, 5) C
PROBLEM NO. 4
The adjusted trial balance of Galimuyod Company as of December 31, 2005 shows the following:
Debit Credit
Allowance for bad debts P40,000
Additional information:
• Cash sales of the company represents 10% of gross sales.

• 90% of the credit sales customers do not take advantage of the 2/10, n/30 terms.
• It is expected that cash discount of P6,000 will be taken on accounts receivable outstanding at December 31, 2006.
• Sales returns in 2006 amounted to P400,000. All returns were from charge sales.
• During 2006, accounts totaling to P44,000 were written off as uncollectible; bad debt recoveries during the year
amounted to P3,000.
• The allowance for bad debts is adjusted so that it represents certain percentage of the outstanding accounts
receivable at year end. The required percentage at December 31, 2006 is 150% of the rate used on December 31,
2005.
Questions:
Based on the above and the result of your audit, answer the following:
1. The accounts receivable as of December 31, 2006 is

a. P3,000,000 c. P 333,333
b. P 300,000 d. P2,444,000
2. The allowance for doubtful accounts as of December 31, 2006 is

a. P 20,000 c. P180,000
b. P120,000 d. P146,640
3. The net realizable value of accounts receivable as of December 31, 2006 is

a. P 307,340 c. P2,874,000
b. P2,814,000 d. P2,291,360
4. The doubtful account expense for the year 2006 is

a. P181,000 c. P 21,000
b. P121,000 d. P147,640
Suggested Solution:
Question No. 1
31
Expected cash discounts P 6,000
Divide by percentage of cash discount 0.02
Portion of AR that will be granted cash discounts 300,000
Divide by percentage of total AR estimated to take
advantage of the discount 0.10
Accounts receivable, 12/31/06 P3,000,000
Question No. 2
Multiply by bad debt rate
[(P40,000/P1,000,000) x 1.5] 0.06
Allowance for doubtful accounts, 12/31/06 P 180,000
Question No. 3
Less: Allowance for doubtful accounts P180,000
Allowance for sales discounts 6,000 186,000
Net realizable value, 12/31/06 P2,814,000
Question No. 4
Allow. for doubtful accounts, 12/31/06 P180,000
Add accounts written off 44,000
Total 224,000
Less: Allow. for doubtful accounts, 12/31/05 P40,000
Bad debt recoveries 3,000 43,000
Doubtful accounts expense for 2006 P181,000
Answers: 1) A; 2) C; 3) B; 4) A
PROBLEM NO. 5
In your audit of Lidlidda Plastic Products Co., you noted that the company’s balance sheet shows the accounts receivable
balance at December 31, 2005 as follows:

P3,528,000
During 2006, transactions relating to the accounts were as follows:
• Sales on account, P38,400,000.

• Cash received from collection of current receivable totaled P31,360,000, after discount of P640,000 were allowed
for prompt payment.
• Customers’ accounts of P160,000 were ascertained to be worthless and were written off.
• Bad accounts previously written off prior to 2005 amounting to P40,000 were recovered.
• The company decided to provide P184,000 for doubtful accounts by journal entry at the end of the year.
32
• Accounts receivable of P5,600,000 have been pledged to a local bank on a loan of P3,200,000. Collections of
P1,200,000 were made on these receivables (not included in the collections previously given) and applied as partial
payment to the loan.
Questions:
1. The accounts receivable as of December 31, 2006 is

a. P8,680,000 c. P4,240,000
b. P9,840,000 d. P8,640,000
2. The allowance for doubtful accounts as of December 31, 2006 is

a. P 8,000 c. P184,000
b. P136,000 d. P176,000
3. The net realizable value of accounts receivable as of December 31, 2006 is

a. P8,544,000 c. P8,504,000
b. P8,456,000 d. P4,104,000
4. If receivables are hypothecated against borrowings, the amount of receivables involved should be a. Disclosed in the
statements or notes
b. Excluded from the total receivables, with disclosure
c. Excluded from the total receivables, with no disclosure
d. Excluded from the total receivables and a gain or loss is recognized between the face value and the amount of
borrowings
Suggested Solution:
Question No. 1
Accounts receivable, 12/31/05 P 3,600,000
Add: Sales on account 38,400,000
Bad debt recoveries 40,000
Total 42,040,000
Less: Current receivables collected,
before cash discounts
(P31,360,000 + P640,000) P32,000,000
Accounts written off 160,000
Bad debt recoveries 40,000
Collections made on AR pledged
as collateral 1,200,000 33,400,000
Accounts receivable, 12/31/06 P 8,640,000
Question No. 2
Allowance for doubtful accounts, 12/31/05 P 72,000
33
Add: Bad debt recoveries 40,000
Provision for doubtful accounts 184,000
Total 296,000
Less: Accounts written off 160,000
Allowance for doubtful accounts, 12/31/06 P136,000
Question No. 3
Less allowance for doubtful accounts, 12/31/06 136,000
Question No. 4
Receivables hypothecated or pledged against borrowings should be disclosed.
Answers: 1) D; 2) B; 3) C; 4) A
PROBLEM NO. 6
You were able to obtain the following information from your audit of Magsingal Corporation’s Accounts Receivable and
Allowance for Doubtful Accounts:
• From the general ledger you noted that the Accounts Receivable has a balance of P848,000 as of December 31,
2006. Below is a transcript of the Allowance for Doubtful Accounts:
Debit Credit Balan

ce
January 1 – Balance P20,00
0
July 31 – Write-off P16,000 4,000
December 31- Provision P48,000 P52,00
0
• The summary of the subsidiary ledger as of December 31, 2006 was totaled as follows:
Debit balances:
Under one month P360,000
One to six months 368,000
Over six months 152,000
P880,000
Credit balances:
Alien P 8,000 - OK; additional billing in January, 2006
T. Twister 14,000 - Should have been credited to Apol* Dee Lah 18,000 - Advances on
sales contract
34
P40,000
*Account is one to six months classification
The customers’ ledger is not in agreement with the accounts receivable control. The client requested you to adjust
the control account to the subsidiary ledger after corrections are made.
 It is agreed that 1 percent is adequate for accounts under one month. Accounts one to six months are expected to
require a reserve of 2 percent. Accounts over six months are analyzed as follows:
Definitely bad P 48,000
Doubtful (estimated to be 50% collectible) 24,000
Apparently good, but slow (estimated to be 90% collectible) 80,000

Total P152,000
QUESTIONS:
1. How much is the adjusted balance of Accounts Receivable as of December 31, 2006?
a. P818,000 c. P832,000
b. P846,000 d. P826,000
2. How much is the adjusted balance of the Allowance for Doubtful Accounts as of December 31, 2006?
a. P30,680 c. P30,960
b. P31,240 d. P30,760
3. How much the Doubtful Accounts expense for the year 2006?
a. P74,680 c. P74,960 b. P75,240 d. P74,760
Suggested Solution:
Question No. 1
SL
GL Debit Credit 0 to 1 1 to 6 Over 6
Unadjusted balances 848,000 880,000 40,000 360,000 368,000 152,000
Add (deduct):
Accounts w/ credit
balances 26,000 (14,000) (40,000) (14,000)
Definitely uncollectible
accounts
(48,000) (48,000) (48,000)
Unlocated difference (8,000)
Adjusted balances 818,000 818,000 0 360,000 354,000 104,000
Question No. 2
35
Account Adjusted Required
classification balance Rate Allowance
1 to 1 month P360,000 1% P 3,600
2 to 6 months 354,000 2% 7,080
Over 6 months 104,000 P24,000 – 50% 12,000
P80,000 – 10% 8,000
P30,680
Question No. 3
Doubtful account expense, per books P48,000
Add adjustment to allowance:
Required allowance P30,680
Less balance before required
allowance (P52,000 – P48,000) 4,000 26,680
Doubtful Accounts expense for 2006 P74,680
Answers: 1) A; 2) A; 3) A
PROBLEM NO. 7
In connection with your examination of the financial statements of Nagbukel, Inc. for the year ended December 31,
2006, you were able to obtain certain information during your audit of the accounts receivable and related accounts.
The December 31, 2006 balance in the Accounts Receivable control accounts is P788,000.
The only entries in the Doubtful Accounts Expense account were:
• A credit for P1,296 on December 2, 2006 because Company A remitted in full for the accounts charged off on
October 31, 2006; and
• A debit on December 31 for the amount of the credit to the Allowance for Doubtful Accounts.
The Allowance for Doubtful Accounts schedule is follows:
Debit Credit Balan

ce
January 1, 2006 P14,6
32
October 31, 2006
Uncollectible accounts:
Company A – P1,296
Company B – P3,280
Company C – P2,256 P6,032 8,600
December 31, 2006 P39,400 P48,0
36
00
An aging schedule of the accounts receivable as of December 31, 2006 is presented below:
Amount to which the Allowance

Net debit is to be adjusted after
Age balance adjustments and corrections
have been made
0 to 1 month P372,960 1 percent
1 to 3 months 307,280 2 percent
3 to 6 months 88,720 3 percent
Over 6 months 24,000 Definitely uncollectible, P4,000;
P8,000 is considered 50%
uncollectible; the remainder is
estimated to be 80% collectible.
There is a credit balance in one account receivable (0 to 1 month) of P8,000; it represents an advance on a sales
contract. Also, there is a credit balance in one of the 1 to 3 months account receivable of P2,000 for which merchandise
will be accepted by the customer.
The ledger accounts have not been closed as of December 31, 2006. The Accounts Receivable control account is not in
agreement with the subsidiary ledger. The difference cannot be located, and you decided to adjust the control account
to the sum of the subsidiaries after corrections are made.
QUESTIONS:
1. How much is the adjusted balance of Accounts Receivable as of December 31, 2006?
a. P794,000 c. P798,960
b. P793,200 d. P802,960
a. P20,352 debit c. P24,143 credit

2. How much is the adjusted balance of
b. P24,263 credit d. P19,693 credit the Allowance for Doubtful Accounts
as of December 31, 2006?
Suggested Solution: a. P63,552 c. P18,937
Question b. P23,057 d. P19,057
No. 1
3. How much is the net adjustment to
GL SL 0 to 1 1 to 3 3 to 6 Over the Allowance for Doubtful Accounts?
6
Unadjusted balances 788,000 792,960 372,960 307,280 88,720 24,00 a. P24,493 debit c. P28,943
0 debit
Add (deduct):
b. P15,552 credit d. P29,063
Understatement of
accounts written off
debit
(P6,832-P6,032)
(800) 4. How much is the Doubtful Accounts
Definitely uncollectible
accounts expense for the year 2006?
(4,000) (4,000) (4,00
0) a. P13,961 b. P18,411 c.
Advances from customers P58,456 d. P13,841
8,000 8,000 8,000
Accounts w/ credit balances 5. How much is the net adjustment to
2,000 2,000 2,000 the Doubtful Accounts expense
Unlocated difference 5,760
account?
798,960 380,960 309,280 88,720 20,00
Adjusted balances 798,960
0
37
Question No. 2
Account Adjusted Required

classification balance Rate Allowanc
e
0 to 1 month P380,960 1% P
3,809.60
1 to 3 months 309,280 2% 6,185.60
3 to 6 months 88,720 3% 2,661.60
Over 6 months 20,000 P8,000 – 50% 4,000.00
P12,000 – 20%
2,400.00
P19,056.8
0
Question No. 3
Balance per books P48,000

Add (deduct) adjustments:
AJE No. 1 P1,296
AJE No. 2 ( 800)
AJE No. 3 (4,000)
AJE No. 4 (25,439) (28,943)
Required allowance (See No. 2) P19,057
Adjusting entries affecting Allowance for Doubtful Accounts and Doubtful Accounts Expense
1) Doubtful account expense P1,296
Allowance for doubtful accounts P1,296
To correct entry made in recording recovery of account written off
2) Allowance for doubtful accounts P800
Accounts receivable P 800

To correct understatement of accounts written off
3) Allowance for doubtful accounts P4,000
Accounts receivable P4,000

To write off definitely uncollectible accounts
4) Allowance for doubtful accounts P25,439
Doubtful account expense P25,439
To adjust allowance to required balance Questions No. 4 & 5
Balance per books (P39,400-P1,296) P38,104
Add (deduct) adjustments:
AJE No. 1 P1,296
AJE No. 4 (25,439) (24,143) (5)
Doubtful accounts expense per audit P13,961 (4)

38
Answers: 1) C; 2) D; 3) C; 4) A, 5) C
PROBLEM NO. 8
During your examination of the 2006 financial statements of the Narvacan Company you find that the company does not
provide allowance for doubtful accounts ever since it started operations in 2002. The company’s practice is to directly
write-off as expense doubtful accounts and credit recoveries to income. The company’s contracts are generally for two
years.
Upon your recommendation, the company agreed to change its accounts for 2006 to give effect to doubtful treatment
on the allowance basis. The allowance is to be based on a percentage of sales which is derived from the experience of
prior years. Statistics for 2002 to 2006 are shown as follows:
Year of Sale 2002 2003 2004 2005 2006 Charge Sales P2,400,000 P6,000,000 P7,200,000
P7,800,000 P6,600,000
Accounts
Written off
& Year of
Sale
2002 13,200
2003 36,000 24,000
2004 12,000 96,000 31,200
2005 28,800 108,000 36,000
2006 64,800 120,000 33,600
Recoveries &
Year of
Sale
2002
2003 2,400
Year of Sale 2002 2003 2004 2005 2006
2004 9,600
2005 12,000
2006 14,400
Accounts receivable at December 31, 2006 were as follows:

From 2005 sales P 360,000
From 2006 sales 3,240,000
Total P3,600,000
QUESTIONS:
Based on the above and the result of your audit, you are to provide the answers to the following:
1. The average percentage of net doubtful accounts to charge sales that should be used in setting up the 2006
allowance is
a. 2.50% c. 2.05%
b. 1.90% d. 1.77%
2. How much is the doubtful accounts expense for 2006?

a. P131,400 c. P165,000
b. P218,400 d. P175,200
3. The doubtful accounts expense for 2006 is over(under) stated by

39
a. P223,800 c. (P131,400)
b. P 53,400 d. (P165,000)
4. The net realizable value of accounts receivable as of December 31, 2006 balance sheet is
a. P3,415,200 c. P3,326,400
b. P3,474,600 d. P3,240,000
5. The adjusting journal entry necessary to set up the allowance for doubtful accounts as of December 31, 2006 will
include a debit to Retained Earnings of
a. P223,800 c. P165,000
b. P184,800 d. P 0
Suggested Solution:
Question No. 1
Net AR Year Charge sales AR written-off Recoveries
written-off
2002 P 2,400,000 P 61,200 P 2,400 P 58,800
2003 6,000,000 148,800 9,600 139,200
2004 7,200,000 204,000 12,000 192,000
P15,600,000 P414,000 P24,000 P390,000
Net AR written off P 390,000
Divide by charge sales P15,600,000
Percentage 2.50%
Question No. 2
Doubtful accounts expense for 2006 (P6,600,000 x P2.50%) P165,000
Question
No. 3
Recorded doubtful accounts expense

(P64,800 + P120,000 + P33,600) P214,800
Should be doubtful accounts expense for 2006 165,000
Overstatement of doubtful accounts expense P 53,400
Question
No. 4

Required allowance for doubtful accounts
(see computation below) 184,800
(A) (B) (C) (D)

(A) x 2.5% AR (B)-(C)+(D)
Year Charge sales D/A expense written-off Recoveries Allowance
2005 P 7,800,000 P195,000 P156,000 P14,400 P 53,400
2006 6,600,000 165,000 33,600 - 131,400
P14,400,000 P360,000 P189,600 P14,400 P184,800
Ex. 17-129—Debt Investments.

On January 1, 2018, Ellison Company purchased 12% bonds, having a maturity value of €800,000, for €860,652.
The bonds provide the bondholders with a 10% yield. They are dated January 1, 2018, and mature January 1,
2023, with interest receivable December 31 of each year. Ellison’s business model is to hold these bonds to collect
40
contractual cash flows.
Instructions
(a) Prepare the journal entry at the date of the bond purchase.
(b) Prepare a bond amortization schedule through 2019.
(c) Prepare the journal entry to record the interest received and the amortization for 2018.
(d) Prepare any entries necessary at December 31, 2018, using the fair value option, assuming the fair value of the
bonds is €860,000.
(e) Prepare any entries necessary at December 31, 2019, using the fair value option, assuming the fair value of the
bonds is €840,000.
Solution 17-129
(a) January 1, 2018
Debt Investments..................................................................................... 860,652
Cash............................................................................................ 860,652
(b) Schedule of Interest Revenue and Bond Premium Amortization
12% Bonds Sold to Yield 10%
Cash Interest Premium Carrying Amount

Date Revenue Amortized of Bonds
Received
1/1/18 — — — €860,652
12/31/18 €96,000 €86,065 € 9,935 850,717
12/31/19 96,000 85,072 10,928 839,789
(c) Cash ...............................................................................................96,000
Debt Investments....................................................................... 9,935
Interest Revenue........................................................................ 86,065
(d) December 31, 2018
Debt Investments..................................................................................... 9,283
Unrealized Holding Gain or Loss—
Income (€860,000 – €850,717).................................................. 9,283
(e) December 31, 2018
Unrealized Holding Gain or Loss-Income.................................................. 9,072
Debt Investments
(€849,072 – €840,000)............................................................... 9,072
41
Carrying Value at 12/31/18...................................................................... €860,000
Amortization............................................................................................. (10,928)
Carrying Value at 12/31/19........................................................... €849,072
Ex. 17-130—Debt Investment purchased at a premium.

On January 1, 2019, West Co. purchased €160,000 of 6% bonds for €168,300 (a 5% effective interest rate) as a
non-trading investment. Interest is paid on July 1 and January 1 and the bonds mature on January 1, 2024.
Instructions
(a) Prepare the journal entry on January 1, 2019.
(b) The bonds are sold on November 1, 2019 at 105 plus accrued interest. Record amortization and interest revenue on
the appropriate dates by the effective-interest method (round to the nearest dollar). Prepare all entries required to
properly record the sale.
Solution 17-130
(a) Debt Investments..................................................................................... 168,300
Cash............................................................................................ 168,300
(b) Cash (€160,000  .06  1/2)...................................................................... 4,800
Interest Revenue (€168,300  .05  1/2)................................... 4,208
Debt Investments....................................................................... 592
Interest Receivable (€160,000 x .06 x 1/3)............................................... 3,200
Interest Revenue ((€168,300 - €592) x .05 x 1/3)....................... 2,795
Debt Investments....................................................................... 405
Cash ((€160,000  1.05) + €3,200)............................................................ 171,200
Gain on Sale of Investments....................................................... 697
Debt Investments (€168,300 - €592 - €405) .............................. 167,303
Interest Receivable..................................................................... 3,200
Ex. 17-131—Debt Investment purchased at a discount.

On January 1, 2019, Kirmer Corp. purchased €450,000 of 6% bonds, interest payable on January 1 and July 1, for
€428,800 (a 7% effective interest rate). The bonds mature on January 1, 2025. Record amortization and interest revenue
on the appropriate dates by the effective-interest method (round to the nearest dollar). (Assume bonds are non-
trading.)
Instructions
(a) Prepare the entry for January 1, 2019.
(b) The bonds are sold on October 1, 2019 for €427,000 plus accrued interest. Prepare all entries required to properly
record the sale.
Solution 17-131
(a) Debt Investments.................................................................................... 428,800
Cash............................................................................................ 428,800
(b) Cash (€450,000  .6  1/2)...................................................................... 13,500
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Debt Investments.................................................................................... 1,480
Interest Revenue (€428,800  .07  1/2)................................... 14,980
Interest Receivable (€450,000 x .06 x ¼)................................................. 6,750
Debt Investments.................................................................................... 780
Interest Revenue ((€428,800 + €1,480) x .07 x ¼)...................... 7,530
Cash (€427,000 + €6,750)........................................................................ 433,750
Loss on Sale of Investments.................................................................... 4,060
Debt Investments (€428,800 + €1,480 + €780).......................... 431,060
Interest Receivable..................................................................... 6,750
Ex. 17-135—Impairment.
Bosch Corporation has government bonds classified as held-for-collection at December 31, 2018. These bonds have
a par value of €600,000, an amortized cost of €600,000, and a fair value of €555,000. In evaluating the bonds,
Bosch determines the bonds have a €45,000 permanent decline in value. That is, the company believes that
impairment accounting is now appropriate for these bonds.
Instructions
(a) Prepare the journal entry to recognize the impairment.
(b) What is the new cost basis of the bonds? Given that the maturity value of the bonds is €600,000, should Bosch
Corporation amortize the difference between the carrying amount and the maturity value over the life of the
bonds?
(c) At December 31, 2019, the fair value of the municipal bonds is €570,000. Prepare the entry (if any) to record this
information.
Solution 17-135
(a) The entry to record the impairment is as follows:
Loss on Impairment (€600,000 – €555,000)............................................. 45,000
Debt Investments....................................................................... 45,000
(b) The new cost basis is €555,000. If the bonds are impaired, it is inappropriate to increase (amortize) the asset back
up to its original maturity value.
(c) Debt Investments..................................................................................... 15,000
Recovery of Impairment Loss
(€570,000 – €555,000).......................................................... 15,000
Ex. 17-136—Comprehensive income calculation.
The following information is available for Irwin Company for 2019:
Net Income €120,000
Realized gain on sale of non-trading investments 10,000
Unrealized holding gain arising during the period on
non-trading investments 24,000

43
Instructions
(1) Determine other comprehensive income for 2019.
(2) Compute comprehensive income for 2019.

Solution 17-136
(1) 2019 other comprehensive income = €34,000 (€10,000 realized gain + €24,000 unrealized holding gain).
(2) 2019 comprehensive income = €154,000 (€120,000 + €34,000).
70. On August 1, 2012, Dambro Co. acquired 400, $1,000, 9% bonds at 97 plus accrued interest. The bonds were
dated May 1, 2012, and mature on April 30, 2018, with interest paid each October 31 and April 30. The bonds
will be added to Dambro’s available-forsale portfolio. The preferred entry to record the purchase of the bonds
on August 1, 2012 is
a. Debt Investments ................................................................. 397,000
Cash......................................................................... 397,00
0
b. Debt Investments ................................................................. 388,000
Interest Receivable............................................................... 9,000
Cash......................................................................... 397,00
0
c. Debt Investments ................................................................. 388,000
Interest Revenue.................................................................. 9,000
Cash......................................................................... 397,00
0
d. Debt Investments ................................................................. 400,000
Discount on Debt Investments.................................. 12,00
0
Cash ........................................................................ 397,00
0
70. c Dr. Debt Investments: 400 × $1,000 × .97 = $388,000 Dr.
Interest Revenue: $400,000 × .045 × 3/6 = $9,000 Cr. Cash:
$388,000 + $9,000 = $397,000.
71. Kern Company purchased bonds with a face amount of $600,000 between interest payment dates. Kern
purchased the bonds at 102, paid brokerage costs of $9,000, and paid accrued interest for three months of
$15,000. The amount to record as the cost of this long-term debt investment is
a. $636,000.
b. $621,000.
c. $612,000.
d. $600,000.
($600,000 × 1.02) + $9,000 = $621,000.
Use the following information for questions 72 and 73.
Patton Company purchased $600,000 of 10% bonds of Scott Co. on January 1, 2013, paying $564,150. The bonds
mature January 1, 2023; interest is payable each July 1 and January 1. The discount of $35,850 provides an effective
yield of 11%. Patton Company uses the effectiveinterest method and plans to hold these bonds to maturity.
44
72. On July 1, 2013, Patton Company should increase its Debt Investments account for the Scott Co. bonds by a.
$3,588.
b. $2,056.
c. $1,794.
d. $1,028.
($564,150 × .055) – ($600,000 × .05) = $1,028.
73. For the year ended December 31, 2013, Patton Company should report interest revenue from the Scott Co.
bonds of: a. $63,588.
b. $62,113.
c. $62,052.
d. $60,000.
$564,150 × .055 = $31,028
($564,150 + $1,028) × .055 = $31,085; $31,028 + $31,085 = $62,113.

Landis Co. purchased $1,000,000 of 8%, 5-year bonds from Ritter, Inc. on January 1, 2012, with interest payable on July
1 and January 1. The bonds sold for $1,041,580 at an effective interest rate of 7%. Using the effective-interest method,
Landis Co. decreased the available-for-sale Debt Investments account for the Ritter, Inc. bonds on July 1, 2012 and
December 31, 2012 by the amortized premiums of $3,540 and $3,660, respectively.
74. At December 31, 2012, the fair value of the Ritter, Inc. bonds was $1,060,000. What should Landis Co. report as
other comprehensive income and as a separate component of stockholders' equity?
a. $25,620.
b. $18,420.
c. $7,200.
d. No entry should be made.
$1,060,000 – ($1,041,580 – $3,540 – $3,660) = $25,620.
75. At April 1, 2013, Landis Co. sold the Ritter bonds for $1,030,000. After accruing for interest, the carrying value of
the Ritter bonds on April 1, 2013 was $1,033,750. Assuming Landis Co. has a portfolio of available-for-sale Debt
Investments, what should Landis Co. report as a gain or loss on the bonds?
a. ($29,370).
b. ($21,870).
c. ($3,750).
d. $ 0.
$1,033,750 – $1,030,000 = $3,750.
76. On August 1, 2012, Fowler Company acquired $600,000 face value 10% bonds of Kasnic Corporation at 104 plus
accrued interest. The bonds were dated May 1, 2012, and mature on April 30, 2017, with interest payable each
October 31 and April 30. The bonds will be held to maturity. What entry should Fowler make to record the
purchase of the bonds on August 1, 2012?
a. Debt Investments ................................................................. 624,000
Cash......................................................................... 639,00
0
b. Debt Investments ................................................................. 639,000
Cash......................................................................... 639,00
0
c. Debt Investments ................................................................. 639,000
Interest Revenue...................................................... 15,00
0
Cash......................................................................... 624,00
0
45
d. Debt Investments ................................................................. 600,000
Premium on Bonds............................................................... 39,000
Cash......................................................................... 639,00
0
Dr. Debt Investments: $600,000 × 1.04 = $624,000
Dr. Interest Revenue: $600,000 × .05 × 3/6 = $15,000
Cr. Cash: $624,000 + $15,000 = $639,000.
77. On October 1, 2012, Renfro Co. purchased to hold to maturity, 2,000, $1,000, 9% bonds for $1,980,000 which
includes $30,000 accrued interest. The bonds, which mature on February 1, 2021, pay interest semiannually on
February 1 and August 1. Renfro uses the straight-line method of amortization. The bonds should be reported in
the December 31, 2012 balance sheet at a carrying value of
a. $1,950,000.
b. $1,951,500.
c. $1,980,000.
d. $1,980,500.
$1,950,000 + ($50,000 × 3/100) = $1,951,500.
78. On November 1, 2012, Howell Company purchased 900 of the $1,000 face value, 9% bonds of Ramsey,
Incorporated, for $948,000, which includes accrued interest of $13,500. The bonds, which mature on January 1,
2017, pay interest semiannually on March 1 and September 1. Assuming that Howell uses the straight-line
method of amortization and that the bonds are appropriately classified as available-for-sale, the net carrying
value of the bonds should be shown on Howell's December 31, 2012, balance sheet at
a. $900,000.
b. $934,500.
c. $933,120.
d. $948,000.
$948,000 – $13,500 = $934,500
$934,500 – ($34,500 × 2/50) = $933,120.
79. On November 1, 2012, Horton Co. purchased Lopez, Inc., 10-year, 9%, bonds with a face value of $500,000, for
$450,000. An additional $15,000 was paid for the accrued interest. Interest is payable semiannually on January 1
and July 1. The bonds mature on July 1, 2019. Horton uses the straight-line method of amortization. Ignoring
income taxes, the amount reported in Horton's 2012 income statement as a result of Horton's available-forsale
investment in Lopez was
a. $8,750.
b. $8,333.
c. $7,500.
d. $6,666.
($500,000 × .045) + ($50,000 × 2/80) – $15,000 = $8,750.
80. On October 1, 2012, Menke Co. purchased to hold to maturity, 500, $1,000, 9% bonds for $520,000. An
additional $15,000 was paid for accrued interest. Interest is paid semiannually on December 1 and June 1 and
the bonds mature on December 1, 2016. Menke uses straight-line amortization. Ignoring income taxes, the
amount reported in Menke's 2012 income statement from this investment should be
a. $11,250.
b. $10,050.
c. $12,450.
d. $13,650.
($500,000 × .09 × 3/12) – ($20,000 × 3/50) = $10,050.
81. During 2010, Hauke Co. purchased 3,000, $1,000, 9% bonds. The carrying value of the bonds at December 31,
2012 was $2,940,000. The bonds mature on March 1, 2017, and pay interest on March 1 and September 1.
46
Hauke sells 1,500 bonds on September 1, 2014, for $1,482,000, after the interest has been received. Hauke uses
straight-line amortization. The gain on the sale is
a. $0.
b. $7,200.
c. $12,000.
d. $16,800.
Discount amortization: $60,000 × 8/50 = $9,600
($2,940,000 + $9,600) ÷ 2 = $1,474,800; $1,482,000 – $1,474,800 = $7,200 gain.
Use the following information for 82 and 83.
On January 3, 2012, Moss Co. acquires $400,000 of Adam Company’s 10-year, 10% bonds at a price of $425,672 to
yield 9%. Interest is payable each December 31. The bonds are classified as held-to-maturity.
82. Assuming that Moss Co. uses the effective-interest method, what is the amount of interest revenue that would
be recognized in 2013 related to these bonds?
a. $40,000
b. $42,568
c. $38,312
d. $38,160
($425,672 × .09) – ($400,000 × .10) = ($1,688) ($425,672 – $1,688) × .09 = $38,160.
83. Assuming that Moss Co. uses the straight-line method, what is the amount of premium amortization that would
be recognized in 2014 related to these bonds?
a. $2,568
b. $1,688
c. $1,840
d. $2,008
($425,672 – $400,000) ÷ 10 = $2,568.
Questions 84 and 85 are based on the following information:
Richman Co. purchased $600,000 of 8%, 5-year bonds from Carlin, Inc. on January 1, 2012, with interest payable on
July 1 and January 1. The bonds sold for $624,948 at an effective interest rate of 7%. Using the effective interest
method, Richman Co. decreased the available-for-sale Debt Investments account for the Carlin, Inc. bonds on July 1,
2012 and December 31, 2012 by the amortized premiums of $2,124 and $2,196, respectively.
84. At December 31, 2012, the fair value of the Carlin, Inc. bonds was $636,000. What should Richman Co. report as
other comprehensive income and as a separate component of stockholders’ equity?
a. $0
b. $4,320
c. $11,052
d. $15,372
$636,000 – ($624,948 – $2,124 – $2,196) = $15,372.
85. At February 1, 2013, Richman Co. sold the Carlin bonds for $618,000. After accruing for interest, the carrying
value of the Carlin bonds on February 1, 2013 was $620,250. Assuming Richman Co. has a portfolio of available-
for-sale debt investments, what should Richman Co. report as a gain (or loss) on the bonds?
a. $0.
b. ($2,250).
c. ($13,122).
d. ($17,622).
$620,250 – $618,000 = $2,250.
47
86. During 2012 Logic Company purchased 6,000 shares of Midi, Inc. for $30 per share. The investment was
classified as a trading security. During the year Logic Company sold 1,500 shares of Midi, Inc. for $35 per share.
At December 31, 2012 the market price of
Midi, Inc.’s stock was $28 per share. What is the total amount of gain/(loss) that Logic Company will
report in its income statement for the year ended December 31, 2012 related to its investment in Midi,
Inc. stock?
a. ($12,000)
b. $7,500
c. ($4,500)
d. ($1,500)
[($35 – $30) × 1,500] – [($30 – $28) × 4,500] = ($1,500).
Instrument Corp. has the following investments which were held throughout 2012–2013:
Fair Value
Cost 12/31/12 12/31/13
Trading $450,000 $600,000 $570,000
Available-for-sale 450,000 480,000 540,000
87. What amount of gain or loss would Instrument Corp. report in its income statement for the year ended
December 31, 2013 related to its investments?
a. $30,000 gain.
b. $30,000 loss.
c. $210,000 gain.
d. $120,000 gain.
$600,000 – $570,000 = $30,000 loss.
88. What amount would be reported as accumulated other comprehensive income related to investments in
Instrument Corp.’s balance sheet at December 31, 2012?
a. $60,000 gain.
b. $90,000 gain.
c. $30,000 gain.
d. $180,000 gain.
$480,000 – $450,000 = $30,000 gain.
89. At December 31, 2013, Atlanta Co. has a stock portfolio valued at $120,000. Its cost was $99,000. If the
Securities Fair Value Adjustment (Available-for-Sale) has a debit balance of $6,000, which of the following
journal entries is required at December 31, 2013?
a. Fair Value Adjustment 21,000
(available-for-sale)
Unrealized Holding Gain or Loss-Equity 21,000
b. Fair Value Adjustment 15,000
Unrealized Holding Gain or Loss-Equity 15,000
c. Unrealized Holding Gain or Loss-Equity 21,000
Fair Value Adjustment 21,000
d. Unrealized Holding Gain or Loss-Equity 15,000
Fair Value Adjustment 15,000
($120,000 – $99,000) – $6,000 = $15,000 unrealized gain.
48
90. Kramer Company's trading securities portfolio which is appropriately included in current assets is as follows:
December 31, 2012
Fair Unrealized
Cost Value Gain (Loss)
Catlett Corp. $250,000 $205,000 $(45,000)
Lyman, Inc. 245,000 265,000 20,000
$495,000 $470,000 $(25,000)
Ignoring income taxes, what amount should be reported as a charge against income in Kramer's 2012 income
statement if 2012 is Kramer's first year of operation? a. $0.
b. $20,000.
c. $25,000.
d. $45,000.
$25,000 (unrealized loss).
91. On its December 31, 2012, balance sheet, Trump Co. reported its investment in availablefor-sale securities,
which had cost $600,000, at fair value of $550,000. At December 31, 2013, the fair value of the securities was
$585,000. What should Trump report on its 2013 income statement as a result of the increase in fair value of the
investments in 2013?
a. $0.
b. Unrealized loss of $15,000.
c. Realized gain of $35,000.
d. Unrealized gain of $35,000.
$0 (available-for-sale securities).
92. During 2012, Woods Company purchased 40,000 shares of Holmes Corp. common stock for $630,000 as an
available-for-sale investment. The fair value of these shares was $600,000 at December 31, 2012. Woods sold all
of the Holmes stock for $17 per share on December 3, 2013, incurring $28,000 in brokerage commissions.
Woods Company should report a realized gain on the sale of stock in 2013 of
a. $22,000.
b. $50,000.
c. $52,000.
d. $80,000.
[(40,000 × $17) – $28,000] – $630,000 = $22,000.
On its December 31, 2012 balance sheet, Calhoun Company appropriately reported a $10,000 debit balance in its Fair
Value Adjustment (available-for-sale) account. There was no change during 2013 in the composition of Calhoun’s
portfolio of equity investments held as available-forsale securities. The following information pertains to that portfolio:
Security Cost Fair value at

12/31/13
X $125,000 $160,000
Y 100,000 85,000
Z 175,000 125,000
$400,000 $370,000
93. What amount of unrealized loss on these securities should be included in Calhoun's stockholders' equity section
of the balance sheet at December 31, 2013?
a. $40,000.
b. $30,000.
c. $10,000.
d. $0.
49
($400,000 – $370,000) = $30,000.
94. The amount of unrealized loss to appear as a component of comprehensive income for the year ending
December 31, 2013 is
a. $40,000.
b. $30,000.
c. $10,000.
d. $0.
$10,000 + $30,000 = $40,000.
95. On January 2, 2013 Pod Company purchased 25% of the outstanding common stock of Jobs, Inc. and
subsequently used the equity method to account for the investment. During 2013 Jobs, Inc. reported net income
of $630,000 and distributed dividends of $270,000. The ending balance in the Equity Investments account at
December 31, 2013 was $480,000 after applying the equity method during 2013. What was the purchase price
Pod Company paid for its investment in Jobs, Inc?
a. $255,000
b. $390,000
c. $570,000
d. $705,000
X + [($630,000 – $270,000) × .25] = $480,000
X + $90,000 = $480,000 X=
$390,000.
96. Ziegler Corporation purchased 25,000 shares of common stock of the Sherman Corporation for $40 per share on
January 2, 2010. Sherman Corporation had 100,000 shares of common stock outstanding during 2013, paid cash
dividends of $120,000 during 2013, and reported net income of $400,000 for 2013. Ziegler Corporation should
report revenue from investment for 2013 in the amount of a. $30,000.
b. $70,000.
c. $100,000.
d. $110,000.
$400,000 × (25,000 ÷ 100,000) = $100,000.
Harrison Co. owns 20,000 of the 50,000 outstanding shares of Taylor, Inc. common stock. During 2013, Taylor earns
$1,200,000 and pays cash dividends of $960,000.
97. If the beginning balance in the investment account was $750,000, the balance at December 31, 2013 should be
a. $1,230,000.
b. $990,000.
c. $846,000.
d. $750,000.
$750,000 + [($1,200,000 – $960,000) × (20,000 ÷ 50,000)] = $846,000.
98. Harrison should report investment revenue for 2013 of

a. $480,000.
b. $384,000.
c. $96,000.
d. $0.
$1,200,000 × (20,000 ÷ 50,000) = $480,000.
Use the following information for questions 99 through 102.
The summarized balance sheets of Goebel Company and Dobbs Company as of December 31, 2012 are as follows:
50
Goebel Company
Balance Sheet
December 31, 2012
Assets $1,200,00
0
Liabilities $
150,000
Capital stock 600,000
Retained earnings
450,000
Total equities $1,200,00
Dobbs Company
0
Balance Sheet
December 31, 2012
Assets $900,00
0
Liabilities $225,00
0
Capital stock 555,000
Retained earnings
120,000
Total equities $900,00
0
99. If Goebel Company acquired a 20% interest in Dobbs Company on December 31, 2012 for $195,000 and the fair
value method of accounting for the investment were used, the amount of the debit to Equity Investments
(Dobbs) would have been a. $135,000.
b. $111,000.
c. $195,000.
d. $180,000.
100. If Goebel Company acquired a 30% interest in Dobbs Company on December 31, 2012 for $225,000 and the
equity method of accounting for the investment were used, the amount of the debit to Equity Investments
(Dobbs) would have been
a. $285,000.
b. $225,000.
c. $180,000.
d. $202,500.
101. If Goebel Company acquired a 20% interest in Dobbs Company on December 31, 2011 for $135,000 and during
2013 Dobbs Company had net income of $75,000 and paid a cash dividend of $30,000, applying the fair value
method would give a debit balance in the Equity Investments (Dobbs) account at the end of 2013 of
a. $111,000.
b. $135,000.
c. $150,000.
d. $144,000.
102. If Goebel Company acquired a 30% interest in Dobbs Company on December 31, 2012 for $210,000 and during
2013 Dobbs Company had net income of $75,000 and paid a cash dividend of $30,000, applying the equity
method would give a debit balance in the Equity Investments (Dobbs) account at the end of 2013 of
a. $210,000.
b. $223,500.
c. $232,500.
d. $201,000.
$210,000 + ($75,000 × .3) – ($30,000 × .3) = $223,500.
51
Blanco Company purchased 200 of the 1,000 outstanding shares of Darby Company's common stock for $600,000 on
January 2, 2013. During 2013, Darby Company declared dividends of $100,000 and reported earnings for the year of
$400,000.
103. If Blanco Company used the fair value method of accounting for its investment in Darby Company, its Equity
Investments (Darby) account on December 31, 2013 should be
a. $580,000.
b. $660,000.
c. $600,000.
d. $680,000.
104. If Blanco Company uses the equity method of accounting for its investment in Darby Company, its Equity
Investments (Darby) account at December 31, 2013 should be
a. $580,000.
b. $600,000.
c. $660,000.
d. $680,000.
$600,000 + ($400,000 × .2) – ($100,000 × .2) = $660,000.
Brown Corporation earns $600,000 and pays cash dividends of $200,000 during 2012. Dexter Corporation owns 3,000
of the 10,000 outstanding shares of Brown.
105. What amount should Dexter show in the investment account at December 31, 2012 if the beginning of the year
balance in the account was $800,000?
a. $980,000.
b. $800,000.
c. $920,000.
d. $1,200,000.
$800,000 + ($600,000 × .3) – ($200,000 × .3) = $920,000.
106. How much investment revenue should Dexter report in 2012?
a. $200,000.
b. $180,000.
c. $120,000.
d. $600,000.
$600,000 × .3 = $180,000.
107. Myers Co. acquired a 60% interest in Gannon Corp. on December 31, 2012 for $1,260,000. During 2013, Gannon
had net income of $800,000 and paid cash dividends of $200,000. At December 31, 2013, the balance in the
investment account should be
a. $1,260,000.
b. $1,740,000.
c. $1,620,000.
d. $1,860,000.
$1,260,000 + ($800,000 × .6) – ($200,000 × .6) = $1,620,000.
Tracy Co. owns 4,000 of the 10,000 outstanding shares of Penn Corp. common stock. During 2013, Penn earns $360,000
and pays cash dividends of $120,000.
108. If the beginning balance in the investment account was $720,000, the balance at December 31, 2013 should be
a. $720,000.
52
b. $816,000.
c. $864,000.
d. $960,000.
$720,000 + ($360,000 × .4) – ($120,000 × .4) = $816,000.
109. Tracy should report investment revenue for 2013 of

a. $48,000.
b. $96,000.
c. $120,000.
d. $144,000.
$360,000 × .4 = $144,000.
110. The following information relates to Windom Company for 2013:

Realized gain on sale of available-for-sale securities $30,000
Unrealized holding gains arising during the period on
available-for-sale securities 70,000

Reclassification adjustment for gains included in net income 20,000 Windom’s 2013 other
comprehensive income is
a. $50,000.
b. $80,000.
c. $100,000.
d. $120,000.
$30,000 + $70,000 – $20,000 = $80,000.
111. On October 1, 2012, Wenn Co. purchased 800 of the $1,000 face value, 8% bonds of Loy, Inc., for $936,000,
including accrued interest of $16,000. The bonds, which mature on January 1, 2019, pay interest semiannually
on January 1 and July 1. Wenn used the straight-line method of amortization and appropriately recorded the
bonds as available-forsale. On Wenn's December 31, 2013 balance sheet, the carrying value of the bonds is a.
$920,000.
b. $912,000.
c. $908,800.
d. $896,000.
$936,000 – $16,000 = $920,000
15
$920,000 – ($120,000 × — ) = $896,000.
75
112. Valet Corp. began operations in 2013. An analysis of Valet’s equity securities portfolio acquired in 2013 shows
the following totals at December 31, 2013 for trading and available-for-sale securities:
Trading Available-for-Sale
Securities Securities
Aggregate cost $90,000 $110,000 Aggregate fair value 70,000 95,000

What amount should Valet report in its 2013 income statement for unrealized holding loss?
a. $35,000.
b. $5,000.
c. $15,000.
d. $20,000.
$90,000 – $70,000 = $20,000.
53
113. At December 31, 2013, Jeter Corp. had the following equity securities that were purchased during 2013, its first
year of operation:
Fair Unrealized
Cost Value Gain (Loss)
Trading Securities:
Security A $ 95,000 $ 60,000 $(35,000)
B 15,000 20,000 5,000
Totals $110,000 $ 80,000 $(30,000)
Available-for-Sale Securities:
Security Y $ 70,000 $ 80,000 $ 10,000
Z 85,000 55,000 (30,000) Totals $155,000 $135,000 $(20,000) All market declines are considered
temporary. Fair value adjustments at December 31, 2013 should be established with a corresponding charge
against
Income Stockholders’ Equity

a. $50,000 $ 0
b. $35,000 $30,000
c. $30,000 $20,000
d. $30,000 $ 0
114. On December 29, 2013, James Co. sold an equity security that had been purchased on January 4, 2012. James
owned no other equity securities. An unrealized holding loss was reported in the 2012 income statement. A
realized gain was reported in the 2013 income statement. Was the equity security classified as available-for-
sale and did its 2012 market price decline exceed its 2013 market price recovery?
2012 Market Price
Decline Exceeded 2013
Available-for-Sale Market Price Recovery
a. Yes Yes
b. Yes No
c. No Yes
d. No No
Rich, Inc. acquired 30% of Doane Corp.'s voting stock on January 1, 2012 for $600,000. During 2012, Doane earned
$240,000 and paid dividends of $150,000. Rich's 30% interest in Doane gives Rich the ability to exercise significant
influence over Doane's operating and financial policies. During 2013, Doane earned $300,000 and paid dividends of
$90,000 on April 1 and $90,000 on October 1. On July 1, 2013, Rich sold half of its stock in Doane for $396,000 cash.
115. Before income taxes, what amount should Rich include in its 2012 income statement as a result of the
investment?
a. $240,000.
b. $150,000.
c. $72,000.
d. $45,000.
$240,000 × 30% = $72,000.
116. The carrying amount of this investment in Rich's December 31, 2012 balance sheet should be
54
a. $600,000.
b. $627,000.
c. $672,000.
d. $690,000.
$600,000 + $72,000 – ($150,000 × 30%) = $627,000.
117. What should be the gain on sale of this investment in Rich's 2013 income statement?
a. $96,000.
b. $82,500.
c. $73,500.
d. $60,000.
$627,000 – ($90,000 × 30%) + ($300,000 × 50% × 30%) = $645,000. $396,000 – ($645,000 ÷
2) = $73,500.
118. On January 1, 2013, Reston Co. purchased 25% of Ace Corp.'s common stock; no goodwill resulted from the
purchase. Reston appropriately carries this investment at equity and the balance in Reston’s investment
account was $960,000 at December 31, 2013. Ace reported net income of $600,000 for the year ended
December 31, 2013, and paid common stock dividends totaling $240,000 during 2013. How much did Reston
pay for its 25% interest in Ace?
a. $870,000.
b. $1,020,000.
c. $1,050,000.
d. $1,170,000.
$960,000 – ($600,000 × 25%) + ($240,000 × 25%) = $870,000.
119. On December 31, 2012, Patel Co. purchased equity investments as trading securities.
Pertinent data are as follows:
Fair Value
Investment Cost At 12/31/13
A $132,000 $117,000 B 168,000 186,000 C 288,000 268,000

On December 31, 2013, Patel transferred its investment in security C from trading to available-for-sale because
Patel intends to retain security C as a long-term investment. What total amount of gain or loss on its securities
should be included in Patel's income statement for the year ended December 31, 2013?
a. $3,000 gain.
b. $17,000 loss.
c. $20,000 loss.
d. $35,000 loss.
$18,000 – $15,000 – $20,000 = $17,000 loss.
Ex. 17-120—Investment in debt securities at premium.

On April 1, 2012, West Co. purchased $320,000 of 6% bonds for $332,600 plus accrued interest as an available-for-sale
security. Interest is paid on July 1 and January 1 and the bonds mature on July 1, 2017.
Instructions
(a) Prepare the journal entry on April 1, 2012.
55
(b) The bonds are sold on November 1, 2013 at 103 plus accrued interest. Amortization was recorded when interest
was received by the straight-line method (by months and round to the nearest dollar). Prepare all entries required
to properly record the sale.
Solution 17-120
(a) Debt Investments........................................................................... 332,600
Interest Revenue ($320,000 × .06 × 1/4)....................................... 4,800
Cash ................................................................................. 337,40
0
(b) Interest Revenue ($12,600 × 4 ÷ 63)............................................. 800
Debt Investments.............................................................. 800
Cash ($320,000 × .06 × 1/3) .......................................................... 6,400

Interest Revenue .............................................................. 6,400
Cash............................................................................................... 329,600
Gain on Sale of Investments............................................. 800
Debt Investments ............................................................. 328,80
$332,600 – [($12,600 ÷ 63) × 19] 0
Ex. 17-121—Investment in debt securities at a discount.

On May 1, 2012, Kirmer Corp. purchased $600,000 of 12% bonds, interest payable on January 1 and July 1, for
$562,600 plus accrued interest. The bonds mature on January 1, 2018. Amortization is recorded when interest is
received by the straight-line method (by months and round to the nearest dollar). (Assume bonds are available for
sale.)
Instructions
(a) Prepare the entry for May 1, 2012.
(b) The bonds are sold on August 1, 2013 for $565,000 plus accrued interest. Prepare all entries required to properly
record the sale.
Solution 17-121
(a) Debt Investments.......................................................................... 562,600 Interest Revenue ($600,000
× .12 × 4/12).................................... 24,000
Cash.................................................................................. 586,600
(b) Debt Investments ($37,400 ÷ 68 × 1)............................................ 550

Interest Revenue............................................................... 550
Cash ($600,000 × .12 × 1/12)....................................................... 6,000
Interest Revenue............................................................... 6,000
Cash.............................................................................................. 565,000 Loss on Sale of

Investments......................................................... 5,850
Debt Investments .............................................................. 570,850

$562,600 + [($37,400 ÷ 68) × 15]
Ex. 17-126—Comprehensive income calculation.
The following information is available for Irwin Company for 2013:
Net Income $120,00

0
Realized gain on sale of available-for-sale securities 10,000
56
Unrealized holding gain arising during the period on
available-for-sale securities 29,000
Reclassification adjustment for gains included in net
income 8,000
Instructions
(1) Determine other comprehensive income for 2013.
(2) Compute comprehensive income for 2013.
Solution 17-126
(1) 2013 other comprehensive income = $31,000 ($10,000 realized gain + $29,000 unrealized holding gain – $8,000
reclassification adjustment).
(2) 2013 comprehensive income = $151,000 ($120,000 + $31,000).
Pr. 17-129—Trading equity securities.

Korman Company has the following securities in its portfolio of trading securities on December 31, 2012:
Cost Fair
Value
5,000 shares of Thomas Corp., Common $159,000 $139,000
10,000 shares of Gant, Common 182,000 190,000
$341,000 $329,000
All of the securities had been purchased in 2012. In 2013, Korman completed the following securities transactions:
March 1 Sold 5,000 shares of Thomas Corp., Common @ $31 less fees of $1,500.
April 1 Bought 600 shares of Werth Stores, Common @ $45 plus fees of $550.
Pr. 17-129 (cont.)
The Korman Company portfolio of trading securities appeared as follows on December 31, 2013:
Cost Fair Value
10,000 shares of Gant, Common $182,000 $195,500
600 shares of Werth Stores, Common 27,550 25,500
$209,550 $221,000
Instructions
Prepare the general journal entries for Korman Company for:
(a) the 2012 adjusting entry.

(b) the sale of the Thomas Corp. stock.
(c) the purchase of the Werth Stores' stock.
(d) the 2013 adjusting entry.
Solution 17-129
(a) 12-31-12
Unrealized Holding Gain or Loss—Income .................................. 12,000
Fair Value Adjustment (trading)........................................ 12,000
($341,000 – $329,000)
57
(b) 3-1-13
Cash [(5,000 × $31) – $1,500]...................................................... 153,500 Loss on Sale of
Investments ........................................................ 5,500
Equity Investments ........................................................... 159,000
(c) 4-1-13
Equity Investments....................................................................... 27,550
Cash [(600 × $45) + $550]................................................ 27,550
(d) 12-31-13
Fair Value Adjustment (trading).................................................... 23,450
Unrealized Holding Gain or Loss—Income....................... 23,450
Pr. 17-130—Trading equity securities.

Perez Company began operations in 2011. Since then, it has reported the following gains and losses for its investments
in trading securities on the income statement:
2011 2012 2013
Gains (losses) from sale of trading securities $ 15,000 $(20,000) $ 14,000
Unrealized holding losses on valuation of trading securities (25,000) — (20,000) Unrealized holding
gain on valuation of trading securities — 10,000 —
At January 1, 2014, Perez owned the following trading securities:
Cost
BKD Common (15,000 shares) $450,00
0
LRF Preferred (2,000 shares) 210,00
0
Drake Convertible bonds (100 bonds) 115,00
0
Pr. 17-130 (cont.)

During 2014, the following events occurred:
1. Sold 5,000 shares of BKD for $170,000.

2. Acquired 1,000 shares of Horton Common for $40 per share. Brokerage commissions totaled $1,000.
At 12/31/14, the fair values for Perez's trading securities were:
BKD Common, $28 per share
LRF Preferred, $110 per share Drake Bonds, $1,020

per bond
Horton Common, $45 per share
58
Instructions
(a) Prepare a schedule which shows the balance in the Fair Value Adjustment (trading) account at December 31,
2013 (after the adjusting entry for 2013 is made).
(b) Prepare a schedule which shows the aggregate cost and fair values for Perez's trading securities portfolio at
12/31/14.
(c) Prepare the necessary adjusting entry based upon your analysis in (b) above.
Solution 17-130
(a) Balance 12/31/11 (result of that year's adjusting entry) $(25,000)
Deduct unrealized gain for 2012 10,000
Add: Unrealized loss for 2013 (20,000)
Balance at 12/31/13 $(35,000)
(b) Aggregate cost and fair value for trading securities at 12/31/14
Cost Fair Value
BKD Common 10,000 shares $300,000 $280,000 LRF Preferred 2,000 shares
210,000 220,000 Horton Common, 1,000 shares 41,000 45,000 Drake Bonds,
100 bonds 115,000 102,000
Total $666,000 $647,000
(c) Adjusting entry at 12/31/14:
Fair Value Adjustment (trading) .................................................... 16,000
Unrealized Holding Gain or Loss—Income ....................... 16,000
(Balance at 1/1/14 $35,000
Balance needed at 12/31/14 19,000
Recovery $16,000)
Ex. 17-122—Investments in equity securities.

Presented below are unrelated cases involving investments in equity securities.
Case I. The fair value of the trading securities at the end of last year was 30% below original cost, and this
was properly reflected in the accounts. At the end of the current year, the fair value has increased to 20%
above cost.
Case II. The fair value of an available-for-sale security has declined to less than forty percent of the original
cost. The decline in value is considered to be other than temporary.
Case III. An equity security, whose fair value is now less than cost, is classified as trading but is reclassified
as available-for-sale.
Instructions
Indicate the accounting required for each case separately.
Solution 17-122
Case I. At the end of last year, the company would have recognized an unrealized holding loss and recorded
a Fair Value Adjustment (trading). At the end of the current year, the company would record an unrealized
holding gain that would be reported in the other revenue and gains section. The adjustment account would
now have a debit balance.
59
Solution 17-122 (cont.)
Case II. When the decline in value is considered to be other than temporary, the loss should be recognized
as if it were realized and earnings will be reduced. The fair value becomes a new cost basis.
Case III. The security is transferred at fair value, which is the new cost basis of the security. The Equity
Investments (available-for-sale) account is recorded at fair value, and the Unrealized Holding Loss—Income
account is debited for the unrealized loss. The Equity Investments (trading) account is credited for cost.
Ex. 17-123—Investment in equity securities.
Agee Corp. acquired a 30% interest in Trent Co. on January 1, 2013, for $500,000. At that time, Trent had
1,000,000 shares of its $1 par common stock issued and outstanding. During 2013, Trent paid cash
dividends of $160,000 and thereafter declared and issued a 5% common stock dividend when the fair value
was $2 per share. Trent's net income for 2013 was $360,000. What is the balance in Agee’s equity
investments account at the end of 2013?
Solution 17-123
Cost $500,00
0
Share of net income (.30 × $360,000) 108,00
0
Share of dividends (.30 × $160,000)
(48,000)
Balance in equity investments account $560,00
0
Ex. 17-124—Fair value and equity methods. (Essay)

Compare the fair value and equity methods of accounting for investments in stocks subsequent to acquisition.
Solution 17-124
Under the fair value method, investments are originally recorded at cost and are reported at fair value.
Dividends are reported as other revenues and gains. Under the equity method, investments are originally
recorded at cost. Subsequently, the investment account is adjusted for the investor's share of the investee's
net income or loss and this amount is recognized in the income of the investor. Dividends received from the
investee are reductions in the investment account.
Ex. 17-125—Fair value and equity methods.
Fill in the dollar changes caused in the Investment account and Dividend Revenue or Investment Revenue
account by each of the following transactions, assuming Crane Company uses (a) the fair value method and
(b) the equity method for accounting for its investments in Hudson Company.
(a) Fair Value Method (b) Equity Method
Investment Dividend Investment Investment
Transaction Account Revenue Account Revenue
———————————————————————————————————————————
1. At the beginning of Year 1, Crane bought 40% of
Hudson's common stock at its book value. Total book
value of all Hudson's common stock was $800,000 on
this date.
———————————————————————————————————————————
2. During Year 1, Hudson reported $60,000 of net
income and paid $30,000 of dividends.
———————————————————————————————————————————
3. During Year 2, Hudson reported $30,000 of net
income and paid $40,000 of dividends.
———————————————————————————————————————————
4. During Year 3, Hudson reported a net loss of $10,000
and paid $5,000 of dividends.
60
———————————————————————————————————————————
5. Indicate the Year 3 ending balance in the Investment
account, and cumulative totals for Years 1, 2, and 3
for dividend revenue and investment revenue.
———————————————————————————————————————————
Solution 17-125
———————————————————————————————————————————————
1. 320,000 320,000
———————————————————————————————————————————————
2. 24,000 24,000 12,000 (12,000)
———————————————————————————————————————————————
3. 12,000 12,000 16,000 (16,000)
———————————————————————————————————————————————
4. (4,000) (4,000) 2,000 (2,000)
———————————————————————————————————————————————
5. 320,000 30,000 322,000 32,000
———————————————————————————————————————————————
Pr. 17-131—Available-for-sale equity securities.
During the course of your examination of the financial statements of Doppler Corporation for the year ended
December 31, 2013, you found a new account, "Investments." Your examination revealed that during 2013,
Doppler began a program of investments, and all investment-related transactions were entered in this
account. Your analysis of this account for 2013 follows:
Doppler Corporation
Analysis of Investments
For the Year Ended December 31, 2013
Date—2013 Debit
(a) Credit
Harmon Company Common Stock
Feb. 14 Purchased 4,000 shares @ $55 per share. $220,000 July 26 Received
400 shares of Harmon Company common stock as a stock dividend.
(Memorandum entry in general ledger.) Sept. 28 Sold the 400 shares of
Harmon Company common stock
received July 26 @ $65 per share. $26,00
(b) 0
Debit
Taber Inc., Common Stock Credit
Apr. 30 Purchased 20,000 shares @ $40 per share. $800,000
Oct. 28 Received dividend of $1.20 per share. $24,00
0
1. The fair value for each security as of the 2013 date of each transaction follow:
Security Feb. 14 Apr. 30 July 26 Sept. 28 Dec.
31
Harmon Co. $55 $62 $70 $74
Taber Inc. $40 33
Doppler Corp. 25 28 30 33 35
2. All of the investments of Doppler are nominal in respect to percentage of ownership (5% or less).
3. Each investment is considered by Doppler’s management to be available-for-sale.

Instructions
(1) Prepare any necessary correcting journal entries related to investments (a) and (b).
61
(2) Prepare the entry, if necessary, to record the proper valuation of the available-for-sale equity security
portfolio as of December 31, 2013.
Solution 17-131
(1) (a) Harmon — original purchase 4,000 shares stock dividend
400 shares total holding 4,400 shares
Total cost of $220,000 ÷ Total shares of 4,400 = $50 cost per share
Sold 100 shares
Correct entry:
Cash (400 × $65) ....................................................................... 26,00
0
Equity Investments......................................................... 20,000
Gain on Sale of Investments .......................................... 6,000
Entry made:
Cash........................................................................................... 26,00
0
Correction:
Equity Investments..................................................................... 6,00
0
Gain on Sale of Investments .......................................... 6,000
(b) Taber—should record cash dividend as dividend income.
Correct entry:
Cash........................................................................................... 24,00
0
Dividend Revenue.......................................................... 24,000
Entry made:
Cash........................................................................................... 24,00
0
Correction:
Equity Investments..................................................................... 24,00
0
(To properly record dividends under fair value
method)
(2) Valuation at End of Year:
Increase
Quantity Cost Fair Value (Decreas
e)
Harmon 4,000 shares $ 200,000 $296,000 $ 96,000
Taber 20,000 shares 800,000 660,000
(140,000
)
$1,000,000 $956,000 $
62
( 44,000)
Year-end Adjustment:
Unrealized Holding Gain or Loss—Equity........................................ 44,000
Fair Value Adjustment (available-for-sale) ........................ 44,000
Ex. 17-132—Investment in equity securities.

Agee Corp. acquired a 25% interest in Trent Co. on January 1, 2019, for £500,000. At that time, Trent had
1,000,000 shares of its $1 par common stock issued and outstanding. During 2019, Trent paid cash dividends
of £160,000 and thereafter declared and issued a 5% ordinary share dividend when the fair value was £2 per
share. Trent's net income for 2019 was £360,000. What is the balance in Agee’s investment account at the end
of 2019?
Solution 17-132
Cost £500,000
Share of net income (.25 × £360,000) 90,000
Share of dividends (.25 × £160,000) (40,000)
Balance in investment account £550,00
Ex. 17-133—Fair value and equity methods. (Essay)
Compare the fair value and equity methods of accounting for investments in shares subsequent to acquisition.
Solution 17-133
Under the fair value method, investments are originally recorded at cost and are reported at fair value.
Dividends are reported as other income and expense. Under the equity method, investments are originally
recorded at cost. Subsequently, the investment account is adjusted for the investor's share of the investee's
net income or loss and this amount is recognized in the income of the investor. Dividends received from the
investee are reductions in the investment account.
Ex. 17-134—Fair value and equity methods.
Fill in the dollar changes caused in the Investment account and Dividend Revenue or Investment Revenue
account by each of the following transactions, assuming Crane Company uses (a) the fair value method and
(b) the equity method for accounting for its investments in Hudson Company.

———————————————————————————————————————————
1. At the beginning of Year 1, Crane bought 30% of
Hudson's ordinary shares at their book value. Total
book value of all Hudson's ordinary shares was
€800,000 on this date.
———————————————————————————————————————————
2. During Year 1, Hudson reported €60,000 of net income
and paid €30,000 of dividends.
———————————————————————————————————————————
3. During Year 2, Hudson reported €30,000 of net income
———————————————————————————————————————————
63
4. During Year 3, Hudson reported a net loss of €10,000
———————————————————————————————————————————
5. Indicate the Year 3 ending balance in the Investment
account, and cumulative totals for Years 1, 2, and 3 for
dividend revenue and investment revenue.
———————————————————————————————————————————
Solution 17-134
———————————————————————————————————————————————
1. 240,000 240,000
———————————————————————————————————————————————
2. 18,000 18,000
9,000 (9,000)
———————————————————————————————————————————————
3. 9,000 9,000
12,000 (12,000)
———————————————————————————————————————————————
4. (3,000) (3,000)
1,500 (1,500)
———————————————————————————————————————————————
5. 240,000 22,500 241,500 24,000

———————————————————————————————————————————————
Pr. 17-139—Trading equity investments.
Korman Company has the following securities in its portfolio of trading equity investments on December 31, 2018:
Cost Fair Value
5,000 ordinary shares of Thomas Corp. €155,000 €139,000
10,000 ordinary shares of Gant 182,000 190,000
€337,000 €329,000
All of the investments had been purchased in 2018. In 2019, Korman completed the following investment
transactions:
March 1 Sold 5,000 ordinary shares of Thomas Corp., @ €31 less fees of €1,500.
April 1 Bought 600 ordinary shares of Werth Stores, @ €45 plus fees of €550.
The Korman Company portfolio of trading equity investments appeared as follows on December 31, 2019:
Cost Fair Value
10,000 ordinary shares of Gant €182,000 €195,500
600 ordinary shares of Werth Stores 27,550 25,500
64
€209,550 €221,000
Instructions
Prepare the general journal entries for Korman Company for:
(a) the 2018 adjusting entry.
(b) the sale of the Thomas Corp. shares.
(c) the purchase of the Werth Stores' shares.
(d) the 2019 adjusting entry.
65
Solution 17-139
(a) 12-31-18
Unrealized Holding Gain or Loss—Income................................... 8,000
Fair Value Adjustment....................................................... 8,000
(€337,000 – €329,000)
(b) 3-1-19
Cash [(5,000  €31) – €1,500]..................................................... 153,500
Loss on Sale of Investments......................................................... 1,500
Equity Investment............................................................. 155,000
(c) 4-1-19
Equity Investments....................................................................... 27,550
Cash [(600  €45) + €550]............................................... 27,550
(d) 12-31-19
Fair Value Adjustment.................................................................. 19,450
[(€221,000 – €209,550) + €8,000]
Pr. 17-140—Trading equity investments.
Perez Company began operations in 2017. Since then, it has reported the following gains and losses for its
investments in trading securities on the income statement:
2017 2018 2019

Gains (losses) from sale of trading investments € 15,000 € (20,000) € 14,000
Unrealized holding losses on valuation of trading investments (25,000) — (30,000)
Unrealized holding gain on valuation of trading investments — 10,000 —
At January 1, 2020, Perez owned the following trading securities:
Cost
BKD Ordinary (15,000 shares) €450,000
LRF Preference (2,000 shares) 210,000
Drake Convertible bonds (100 bonds) 115,000
During 2020, the following events occurred:
1. Sold 5,000 shares of BKD for €170,000.
2. Acquired 1,000 ordinary shares of Horton for €40 per share. Brokerage fees totaled €1,000.
At 12/31/20, the fair values for Perez's trading investments were:
BKD Ordinary, €28 per share
LRF Preference, €110 per share
66
Drake Bonds, €1,020 per bond
Horton Ordinary, €42 per share
Instructions
(a) Prepare a schedule which shows the balance in the Fair Value Adjustment at December 31, 2019 (after
the adjusting entry for 2019 is made).
(b) Prepare a schedule which shows the aggregate cost and fair values for Perez's trading investments
portfolio at 12/31/20.
(c) Prepare the necessary adjusting entry based upon your analysis in (b) above.
Solution 17-140
(a) Balance 12/31/17 (result of that year's adjusting entry) € (25,000)
Deduct unrealized gain for 2018 10,000
Add: Unrealized loss for 2019 (30,000)
Balance at 12/31/19 € (45,000)
(b) Aggregate cost and fair value for trading securities at 12/31/20:
Cost Fair Value
BKD Ordinary 10,000 shares €300,000 €280,000
LRF Preference 2,000 shares 210,000 220,000
Horton Ordinary, 1,000 shares 41,000 42,000
Drake Bonds, 100 bonds 115,000 102,000
Total €666,000 €644,000
(c) Adjusting entry at 12/31/20:
Fair Value Adjustment.................................................................. 23,000
(Balance at 1/1/17 €45,000
Balance needed at 12/31/20 22,000
Recovery €23,000)
Pr. 17-141—Non-trading equity investments.
During the course of your examination of the financial statements of Doppler Corporation for the year ended
December 31, 2019, you found a new account, "Investments." Your examination revealed that during 2019,
Doppler began a program of investments, and all investment-related transactions were entered in this account.
Your analysis of this account for 2019 follows:
Doppler Corporation
Analysis of Investments
For the Year Ended December 31, 2019
Date—2019 Debit Credit
(a)
Harmon Company Ordinary Shares
Feb. 14 Purchased 4,000 shares @ £55 per share. £220,000
July 26 Received 400 ordinary shares of Harmon Company
67
as a share dividend. (Memorandum entry in general ledger.)
Sept. 28 Sold the 400 ordinary shares of Harmon Company
received July 26 @ £70 per share. £28,000
(b)
Debit Credit
Taber Inc., Ordinary Shares
Apr. 30 Purchased 20,000 shares @ £40 per share. £800,000
Oct. 28 Received dividend of £1.20 per share. £24,000
Pr. 17-141 (cont.)
1. The fair value for each security as of the 2016 date of each transaction follow:
Security Feb. 14 Apr. 30 July 26 Sept. 28 Dec. 31

Harmon Co. £55 £62 £70 £74
Taber Inc. £40 32
Doppler Corp. 25 28 30 33 35
2. All of the investments of Doppler are nominal in respect to percentage of ownership (5% or less).
3. Each investment is considered by Doppler’s management to be non-trading.
Instructions
(1) Prepare any necessary correcting journal entries related to investments (a) and (b).
(2) Prepare the entry, if necessary, to record the proper valuation of the non-trading equity investment
portfolio as of December 31, 2019.
Solution 17-141
(1) (a) Harmon — original purchase 4,000 shares
share dividend 400 shares
total holding 4,400 shares
Total cost of $220,000 ÷ Total shares of 4,400 = £50 cost per share
Sold 400 shares
Correct entry:
Cash (400 × £70)....................................................................... 28,000
Equity Investments (400 × £50)..................................... 20,000
Gain on Sale of Investments.......................................... 8,000
Entry made:
Cash.......................................................................................... 28,000
Correction:
Equity Investments.................................................................... 8,000
Gain on Sale of Investments.......................................... 8,000
(b) Taber—should record cash dividend as dividend income.
68
Correct entry:
Cash.......................................................................................... 24,000
Entry made:
Cash.......................................................................................... 24,000
Correction:
Equity Investments.................................................................... 24,000

(To properly record dividends under fair value
method)
(2) Valuation at End of Year:
Increase
Quantity Cost Fair Value (Decrease)
Harmon 4,000 shares £ 200,000 £296,000 £ 96,000
Taber 20,000 shares 800,000 640,000 (160,000)
£1,000,000 £936,000 £ (64,000)
Year-end Adjustment:
Unrealized Holding Gain or Loss—Equity........................................ 64,000
Fair Value Adjustment....................................................... 64,000
A U.S. company invests in a forward purchase contract for 100,000,000 yen with a purchase price of
$0.009/yen, for delivery in 45 days. The spot rate at the time the contract is initiated is $0.0085/yen. At the
end of the accounting year, the forward contract is still outstanding. The year-end spot rate is $0.0088/yen.
The year-end forward rate for delivery at the contract date is $0.0092/yen. How is the forward contract
reported on the U.S. company’s balance sheet?
a. $20,000 asset
b. $20,000 liability
c. $30,000 asset
d. $30,000 liability
ANS: a
($0.0092 - $0.009) x 100,000,000 = $20,000
69
2. Topic: Cash flow hedge
LO 6
1On August 1, a U.S. company enters into a forward contract, in which it agrees to buy 1,000,000 euros
from a bank at a rate of $1.115 on December 1. Changes in the value of the forward contract will be
reported in other comprehensive income on the balance sheet in which one of the following situations?
a. The U.S. company has receivables denominated in euros, with payment to be received on
December 1.
b. The U.S. company sold merchandise to a customer in Belgium on August 1, and expects
payment of 1,000,000 euros on December 1.
c. The U.S. company plans to sell merchandise to a customer in Belgium on August 1, with
payment of 1,000,000 euros expected on December 1.
d. The U.S. company plans to purchase merchandise from a supplier in Belgium, with payment of
1,000,000 euros expected to be paid on December 1.
ANS: d
70
Use the following information on the U.S. dollar value of the euro to answer questions 3 – 7 below:
Forward rate for

April 30, 2011
delivery
Spot rate
October 30, 2010 $ 1.25 $ 1.30
December 31, 2010 1.28 1.32
April 30, 2011 1.26 1.26
On October 30, 2010, a company enters a forward contract to sell €100,000 on April 30, 2011. The company’s
accounting year ends December 31.
3. Topic: Hedge of export transaction

LO 4
The forward contract hedges an outstanding €100,000 account receivable due on April 30. What is the
net effect on income in 2010 and 2011?
2010 2011
a. $1,000 gain $4,000 gain
b. $1,000 loss $4,000 gain
c. $3,000 gain $6,000 gain
d. $2,000 loss $6,000 gain
ANS: a
2010: Gain on receivable, ($1.28 - $1.25) x €100,000 = $3,000

Loss on forward, ($1.32 - $1.30) x €100,000 = $2,000
Net gain $1,000
2011: Loss on receivable, ($1.28 - $1.26) x €100,000 = $2,000

Gain on forward, ($1.32 - $1.26) x €100,000 = $6,000
Net gain $4,000
71
4. Topic: Hedge of firm commitment
LO 5
The forward contract hedges a sales order for €100,000, received October 30. The sale was made and
the €100,000 collected on April 30, 2011. Sales revenue recorded on April 30 is:
a. $126,000
b. $122,000
c. $130,000
d. $124,000
ANS: c
(€100,000 x $1.26) + ($1.30 - $1.26) x €100,000 = $130,000

LO 5
The forward contract hedges a sales order for €100,000, received October 30. The sale was made and
the €100,000 collected on April 30, 2011. The net effect on 2010 income is:
a. No effect
b. $2,000 loss
c. $3,000 gain
d. $1,000 gain
ANS: a
The gain on the firm commitment and loss on the forward contract are ($1.32 - $1.30) x €100,000 =
$2,000, and they offset for a zero effect on 2010 income.
72
6. Topic: Hedge of forecasted transaction
LO 6
The forward contract hedges a forecasted sale for €100,000, expected at the end of April 2011. The
net effect on 2010 income is:
a. No effect
b. $2,000 loss
c. $3,000 gain
d. $1,000 gain
ANS: a
The loss on the forward contract is reported in other comprehensive income.

LO 6
The forward contract hedges a forecasted sale for €100,000, expected at the end of April 2011. The
sale takes place on April 30, 2011, €100,000 is collected, and the forward contract is closed. Which
statement is true, concerning the sale on April 30, 2011?
a. The $1,000 total loss on the forward contract is reclassified from other comprehensive income
as an adjustment to sales revenue.
b. The $4,000 total gain on the forward contract is reclassified from other comprehensive income
as an adjustment to sales revenue.
c. The 2011 $6,000 gain on the forward contract is recognized as a hedging gain on the 2011
income statement.
d. The 2010 $2,000 loss on the forward contract is recognized as a hedging loss on the 2010
income statement.
ANS: b
The total gain on the forward contract is ($1.30 - $1.26) x €100,000 = $4,000. Changes in the value of
the forward are reported in other comprehensive income until the hedged forecasted transaction is
reported in income. In this case, the forecasted transaction results in sales revenue, reported in 2011.
73
8. Topic: Export transaction
LO 2
On May 20, 2012, when the spot rate is $1.30/€, a company sells merchandise to a customer in Italy.
The spot rate is $1.31/€ on June 30, the company’s year-end. Payment of €100,000 is received on July
30, 2012, when the spot rate is $1.28/€. What is the effect on fiscal 2012 and 2013 income?
Fiscal 2012 Fiscal 2013

a. $1,000 exchange loss $3,000 exchange gain
b. $1,000 exchange gain $3,000 exchange loss
c. No effect $2,000 exchange loss
d. No effect $2,000 exchange gain
ANS: b
Fiscal 2012 exchange gain = ($1.31 - $1.30) x €100,000 = $1,000

Fiscal 2013 exchange loss = ($1.31 - $1.28) x €100,000 = $3,000
9. Topic: Import transaction

LO 2
On May 20, 2012, when the spot rate is $1.30/€, a company purchases merchandise from a supplier in
Italy. The spot rate is $1.31/€ on June 30, the company’s year-end. Payment of €100,000 is made on
July 30, 2012, when the spot rate is $1.28/€. What is the effect on fiscal 2012 and 2013 income?
Fiscal 2012 Fiscal 2013

a. $1,000 exchange loss $3,000 exchange gain
b. $1,000 exchange gain $3,000 exchange loss
c. No effect $2,000 exchange loss
d. No effect $2,000 exchange gain
ANS: a
Fiscal 2012 exchange loss = ($1.31 – $1.30) x €100,000 = $1,000

Fiscal 2013 exchange gain = ($1.31 – $1.28) x €100,000 = $3,000
74
Data for questions 10 and 11 are as follows:
On September 8, the Sealy Company purchased cotton at an invoice price of €20,000, when the exchange
rate was $1.32/€. Payment was to be made on November 8. On November 8, Sealy purchased the €20,000
for $1.30/€, and paid the invoice.

LO 2
THE COTTON SHOULD BE VALUED IN SEALY'S INVENTORY AT:
a. $20,000
b. $25,600
c. $26,000
d. $26,400
ANS: d
€20,000 x $1.32 = $26,400

LO 2
The exchange gain or loss recognized by Sealy as a result of this transaction is:
a. No gain or loss
b. $400 gain
c. $400 loss
d. $1,667 gain
ANS: b
€20,000 x ($1.32 - $1.30) = $400 gain
75
Data for questions 12 and 13 are as follows:
On June 5, Teneco Corporation sold merchandise at an invoice price of €100,000, when the exchange rate
was $1.36/€. Payment was to be received on August 16. On August 16, the customer paid the €100,000. The
exchange rate on that date was $1.39/€.

LO 2
THE SALE SHOULD BE REPORTED ON TENECO'S BOOKS AT:
a. $136,000
b. $139,000
c. $ 73,530
d. $ 71,942
ANS: a
€100,000 x $1.36 = $136,000

LO 2
THE EXCHANGE GAIN OR LOSS RECOGNIZED BY TENECO AS A RESULT OF THIS TRANSACTION IS:
a. -0-
b. $3,000 gain
c. $3,000 loss
d. $3,919 loss
ANS: b
€100,000 x ($1.39 - 1.36) = $3,000 gain
76
14. Topic: Analysis of foreign currency risks
LO 3
A U.S. exporter has made a sale to a customer in another country. The customer is obligated to remit
payment in his local currency in 90 days. The direct spot rate is now $1.54. The 90-day forward rate is
$1.60. At which spot rate at the time the customer remits payment would the company have been
better off not hedging the export transaction with a forward contract?
a. $1.52
b. $1.54
c. $1.59
d. $1.62
ANS: d
Any rate above $1.60 leads to higher U.S. dollar value of payment received than under the forward
contract.
15. Topic: Foreign currency options

LO 3
A company invests $200 in a foreign exchange option with the following terms: The company may
purchase 1,000,000 zloty at a price of $.25/zloty on December 20, 2014. Which statement is true?
a. If the spot price for zloty is $.36 on December 20, the company will gain $359,800 on the option.
b. If the spot price for zloty is $.24 on December 20, the company will lose $200 on the option.
c. If the spot price for zloty is $.27 on December 20, the company will lose $20,200 on the option.
d. If the spot price for zloty is $.30 on December 20, the company will gain $24,800 on the option.
ANS: b
The option gives the holder the option to buy 1,000,000 zloty for $250,000. At a spot price of
$.24/zloty, the option has no value and the holder loses its $200 investment.
77
16. Topic: Hedge of import transaction
LO 4
A U.S. import company purchases boomerangs from an Australian supplier on October 1, 2013 for
100,000 Australian dollars (A$), payable February 1, 2014. On October 1, 2013, the company enters
into a forward contract to hedge the foreign currency risk resulting from this purchase. Exchange rates
are as follows:
Forward
rate for 2/1
delivery
Spot rate
October 1, 2013 $0.89 $0.85
December 31, 2013 0.88 0.84
February 1, 2014 0.82 0.82
FOR THE IMPORT COMPANY, WHAT IS THE INCOME STATEMENT EFFECT OF THE ABOVE
INFORMATION?
a. No effect in 2013, $4,000 gain in 2014

b. $1,000 gain in 2013, $6,000 gain in 2014
c. $1,000 loss in 2013, $6,000 loss in 2014
d. No effect in 2013, $4,000 loss in 2014
ANS: a
2013:
forward contract: ($.85 - $.84) x A$100,000 = $1,000 loss
payable: ($.89 - $.88) x A$100,000 = 1,000 gain
-0-
2014:
forward contract: ($.84 - $.82) x A$100,000 = $2,000 loss
payable: ($.88 - $.82) x A$100,000 = 6,000 gain
$4,000 gain
78
LO 5
ABC Corporation issues a purchase order for 1,000,000 semiconductors to a foreign supplier. The
agreed upon total price is FC1,200,000, and the current spot rate is $1/FC. Suppose a forward contract
is taken out when the purchase order is issued, at a rate of $0.95/FC, for delivery when the
semiconductors are received. If the spot rate rises to $1.05 when the semiconductors are received and
paid for by ABC, at what value will the semiconductors be reported on ABC’s books?
a. $1,020,000
b. $1,140,000
c. $1,200,000
d. $1,260,000
ANS: b
$1.05 x FC1,200,000 = $1,260,000
($1.05 - $.95) x FC1,200,000 = (120,000)
$1,140,000
Use the following information to answer questions 18 and 19 below.
A U.S. company purchases a 60-day certificate of deposit from an Italian bank on October 15. The certificate
has a face value of €1,000,000, costs $1,200,000 (the spot rate is $1.20/€), and pays interest at an annual rate
of 6 percent. On December 14, the certificate of deposit matures and the company receives principal and
interest of €1,010,000. The spot rate on December 14 is $1.18/€. The average spot rate for the period
October 15 – December 14 is $1.19/€.
18. Topic: Foreign currency lending

LO 2
The exchange gain or loss on this investment is:
a. $20,200 gain
b. $20,200 loss
c. $20,000 gain
d. $20,000 loss
ANS: d
€1,000,000 x ($1.20 - $1.18) = $20,000 loss
79
19. Topic: Foreign currency lending
LO 2
Interest income on the investment is reported at:
a. $0
b. $11,800
c. $11,900
d. $12,000
ANS: b
€10,000 x $1.18 = $11,800
Use the following information to answer questions 20 – 22 below:
A U.S. company anticipates that it will purchase merchandise for €10,000,000 at the end of July, and pay for it
at the end of September. On March 1, it enters a forward contract to buy €10,000,000 on September 30. The
forward contract qualifies as a cash flow hedge. The company’s accounting year ends December 31. The
company actually purchases the merchandise on July 30 and closes the forward contract and pays for the
merchandise on September 30. It still holds the merchandise at the end of the year. Exchange rates are as
follows:
Forward rate
for 9/30
delivery
Spot rate
March 1 $1.40 $1.41
July 30 1.42 1.415
September 30 1.43 1.43
80
LO 6
The merchandise is reported on the year-end balance sheet at:
a. $14,100,000
b. $14,150,000
c. $14,200,000
d. $14,300,000
ANS: c
Changes in the value of the forward contract remain in other comprehensive income until the
merchandise is sold. The merchandise is reported at the spot rate at the date of purchase, $1.42.

LO 6
What is the net effect on income for the year?
a. No effect
b. $100 loss
c. $100 gain
d. $50 gain
ANS: a
Changes in the value of the forward are reported in other comprehensive income. The $100 loss
on the payable is exactly offset by a reclassification of $100 out of other comprehensive income, so
there is no net effect on income.
81
LO 6
When the merchandise is sold, what amount is reported for cost of goods sold?
a. $14,100,000
b. $14,150,000
c. $14,200,000
d. $14,300,000
ANS: a
At the end of the year, other comprehensive income has a credit balance of $100. When the
merchandise is sold, it is reclassified as a reduction in cost of goods sold; $14,100,000 = $14,200,000 -
$100,000.
Journal entries related to questions 20 – 22 (in thousands):
July 30
Inventory 14,200
Accounts payable 14,200
Investment in forward 50
Other comprehensive income 50
September 30
Exchange loss 100
Accounts payable 100


Exchange gain 100

Cash 14,100
When merchandise is sold:

Cost of goods sold 14,100
Inventory 14,200
82
Use the following information on the U.S. dollar value of the euro to answer questions 23 – 25:
Forward rate for

March 20, 2012
delivery
Spot rate
November 30, 2011 $ 1.30 $ 1.29
December 31, 2011 1.33 1.31
March 20, 2012 1.35 1.35
23. Topic: Speculative forward purchase contract

LO 7
On November 30, 2011, a U.S. company, with a December 31 year-end, enters a forward purchase
contract for €100,000 to be delivered on March 20, 2012. The forward contract does not qualify as a
hedge. The company closes the contract at its expiration date. Which statement is true?
a. No gain or loss is reported until the forward is closed on March 20

b. A gain of $2,000 is reported in 2012
c. A gain of $4,000 is reported in 2012
d. A gain of $6,000 is reported in 2012
ANS: c
The change in value of the forward is reported in income as the forward rate changes. For 2012, the
gain is ($1.35 - $1.31) x €100,000 = $4,000.
24. Topic: Speculative forward sale contract

LO 7
On November 30, 2011, a U.S. company, with a December 31 year-end, enters a forward sale
contract for €100,000 to be delivered on March 20, 2012. The forward contract does not qualify as a
hedge. The company closes the forward contract on December 31. Which statement is true?
a. No gain or loss is reported

b. A loss of $1,000 is reported in 2011
c. A loss of $3,000 is reported in 2011
d. A loss of $2,000 is reported in 2011
ANS: d
The change in value of the forward is reported in income as the forward rate changes. For 2011, the
loss is ($1.31 - $1.29) x €100,000 = $2,000
83
25. Topic: IFRS for hedge of a forecasted purchase
LO 8
On November 30, 2011, a U.S. company, with a December 31 year-end, enters a forward purchase
contract for €100,000 to be delivered on March 20, 2012. The contract hedges a forecasted purchase
of equipment. The forward is closed and the equipment purchased on March 20. If the company
follows IFRS and reports gains and losses on hedges of forecasted transactions as basis adjustments,
total depreciation expense over the life of the equipment is:
a. $129,000
b. $130,000
c. $131,000
d. $135,000
ANS: a
The equipment is recorded at the spot rate of $1.35 x €100,000 = $135,000, adjusted for the $6,000 [=
$1.35 - $1.29) x €100,000] gain on the forward contract.
41. Topic: Valuation of forward contracts
LO 3
On December 1, a U.S. company agrees to buy euros on February 1 at a contract price of $1.40. The
company did not pay anything for this contract. The exchange rate for euros declines to $1.38 (U.S.
dollar strengthens) between December 1 and December 31, when the company’s reporting year ends.
How is this contract reported on the company’s year-end balance sheet?
a. In the asset section

b. In the liability section
c. As a contra asset
d. The contract is not reported on the balance sheet
ANS: b
42. Topic: Hedges of firm commitments

LO 5
1On July 10, 2012, a U.S. company with a December 31 year-end enters a forward contract that locks
in the selling price of won, for delivery on August 15. The forward contract hedges a firm commitment
to sell merchandise to a customer in Korea, with payment denominated in won. The sale is made on
August 1, 2012 and payment is received from the customer on August 15. Where is the value of the
firm commitment to sell reported in the year-end financial statements for 2012?
a. Asset or liability on the balance sheet

b. Increase or decrease in other comprehensive income
c. Adjustment to sales revenue
d. Adjustment to cost of goods sold
ANS: c
84
43. Topic: Foreign currency borrowing
LO 2
The XYZ Company borrows 100,000,000 euros by issuing bonds to German investors when the spot
rate is $1.25/€. The interest rate is 10 percent per annum. When XYZ accounts for this loan, which of
the following will not be true?
a. A decrease in the exchange rate will generate an exchange gain on the bonds payable
b. If the spot rate rises to $1.35/€ one year hence, when the interest payment is accrued, the
interest expense will be recorded at $13,500,000
c. If XYZ desires to hedge these bonds, it will have to purchase euros forward
d. The bonds payable will be carried at $125,000,000 until they mature
ANS: d
44. Topic: Foreign currency borrowing

LO 2
Interest expense on a loan denominated in another currency is translated at:
a. The average spot rate for the period the interest covers
b. The spot rate when the loan was made
c. The spot rate when the interest is recorded
d. The forward rate for delivery when the interest must be paid
ANS: c
45. Topic: Hedging strategy

LO 3
1U.S. manufacturers that sell to customers in other countries, priced in the currency of the customer’s
country, often adjust their hedging strategy depending on which way they believe foreign currency rates
are headed. Which statement best represents the adjustment they make, if the U.S. dollar is expected
to weaken?
a. Reduce the percentage of receivables hedged

b. Reduce the percentage of payables hedged
c. Increase the percentage of receivables hedged
d. Increase the percentage of payables hedged
ANS: a
85
46. Topic: Hedge accounting
LO 3
1Two major goals of SFAS 133 are:
a. Disclose the fair values of derivatives investments in the footnotes of the financial statements,
and report hedged assets and liabilities at fair value on the balance sheet.
b. Report the fair values of derivatives investments on the balance sheet, and report hedged
assets and liabilities at fair value on the balance sheet.
c. Report the fair values of derivatives investments on the balance sheet, and match gains and
losses on hedge investments and hedged assets and liabilities on the same income statement.
d. Report hedged assets and liabilities at fair value on the balance sheet, and match gains and
losses on hedge investments and hedged assets and liabilities on the same income statement.
ANS: c

LO 6
1A U.S. company hedges an anticipated sale of merchandise to a foreign customer. When are gains
and losses on the hedge investment reported on the income statement?
a. When the customer pays for the merchandise

b. When the anticipated sale becomes a firm commitment
c. When the hedge investment is determined to be an effective hedge
d. When the merchandise is sold
ANS: d
48. Topic: Speculative investments

LO 7
1A U.S. company enters a forward purchase contract that does not qualify as a hedge investment.
When are gains and losses on the hedge investment reported on the income statement?
a. When the forward contract changes in market value

b. When the forward contract is closed
c. When the forward contract is determined to be an effective hedge
d. When the merchandise is sold
ANS: a
86
49. Topic: Hedge of foreign-currency-denominated payable
LO 4
1A U.S. company has entered into a forward purchase contract to hedge a reported foreign currency
obligation. If the U.S. dollar weakens against the foreign currency:
a. The forward contract appears as a current asset on the company’s balance sheet.
b. The forward contract’s reported value exactly offsets the reported foreign currency obligation,
with no net balance sheet disclosure.
c. The gain on the forward contract adds to other comprehensive income.
d. The gain on the foreign currency obligation adds to other comprehensive income.
ANS: a
50. Topic: IFRS for foreign currency hedging

LO 8
IFRS allows which reporting practice, not allowed under U.S. GAAP?
a. Reporting foreign currency derivative positions at cost rather than at market value
b. Reporting gains and losses on cash flow hedges as adjustments to the carrying value of related
asset acquisitions
c. Reporting gains and losses on firm commitment hedges as adjustments to the carrying value of
related asset acquisitions
d. Reporting foreign currency derivative positions at market rather than at cost
ANS: b
87
PROBLEMS
1. Topic: Fair value hedge of receivables and payables, cash flow hedge of forecasted
transaction
LO 4, 6
Use the following exchange rates for the Canadian dollar to answer the three questions below
concerning a U.S. company’s foreign exchange activities. The company’s accounting year ends
December 31.
Forward rate for

Spot rate March 31, 2011 delivery
October 31, 2010 $ 0.82 $ 0.81
December 31, 2010 0.85 0.86
March 31, 2011 0.83 0.83
Required
Answer the following questions.
a. The company sells merchandise to a Canadian customer for C$100,000 on October 31, 2010,
and receives payment from the customer, in Canadian dollars, on March 31, 2011. What are
the following balances?
i. Sales revenue for 2010
ii. Accounts receivable, December 31, 2010
iii. Exchange gain or loss for 2011
b. The company sells merchandise to a Canadian customer for C$100,000 on October 31, 2010,
and receives payment from the customer, in Canadian dollars, on March 31, 2011. On October
31, 2010 it enters a forward contract to lock in the selling price of Canadian dollars, for March
31, 2011 delivery. On March 31, 2011, it delivers the Canadian dollars and closes the forward
contract. What are the balances?
i. Investment in forward , December 31, 2010
ii. Amount of U.S. dollars received March 31, 2011
c. The company enters a forward contract on October 31, 2010 to hedge a forecasted purchase of
merchandise for C$100,000 on March 31, 2011. On March 31 it takes delivery of the
merchandise, closes the forward and pays for the merchandise. It sells the merchandise in May.
What are the balances?
i. Investment in forward, December 31, 2010 ii. Cost of
goods sold on May sale
88
ANS:
a. i. C$100,000 x $.82 = $82,000

ii. C$100,000 x $.85 = $85,000
iii. C$100,000 x ($.85 - $.83) = $2,000 loss
b. i. C$100,000 x ($.81 - $.86) = $5,000 liability

ii. C$100,000 x $.81 = $81,000
c. i. C$100,000 x ($.81 - $.86) = $5,000 asset

ii. $83,000 – ($.83 - $.81)(C$100,000) = $81,000
2. Topic: Unhedged foreign currency transactions, hedges of firm commitments

LO 2, 4, 5
A U.S. company buys merchandise from suppliers in the U.K., and pays for the merchandise in pounds
sterling. Its accounting year ends December 31. Use the following information on $/£ to answer the
questions below.
Forward rate for delivery

Spot rate March 1, 2013
October 1, 2012 $1.29 $1.28
November 1, 2012 1.30 1.32
December 31, 2012 1.35 1.34
March 1, 2013 1.37 1.37
REQUIRED
Answer the following questions:
a. The U.S. company takes delivery of merchandise costing £1,000,000 on November 1, 2012.
The company pays for the merchandise, in pounds, on March 1, 2013. No hedging is involved.
The company sells the merchandise on June 1, 2013. What amounts will appear on the financial
statements of the U.S. company for:
i. Accounts payable, December 31, 2012 balance sheet
ii. Exchange gain or loss, 2012 income statement
iii. Cost of goods sold, 2013 income statement
b. Assume the same facts as in a. above, but the U.S. company issues a purchase order on
October 1, 2012 before taking delivery on November 1. On October 1 the company also enters
a forward contract to hedge its FX risk, for delivery of pounds on March 1, 2013. What amounts
will appear on the financial statements of the U.S. company for:
i. Investment in forward contract, December 31, 2012 balance sheet
ii. Cost of goods sold, 2013 income statement
89
ANS:
a. i. £1,000,000 x $1.35 = $1,350,000

ii. £1,000,000 x ($1.30 - $1.35) = $50,000 loss
iii. £1,000,000 x $1.30 = $1,300,000
b. i. £1,000,000 x ($1.28 - $1.34) = $60,000 asset

ii. £1,000,000 x $1.30 – [£1,000,000 x ($1.28 - $1.32)] = $1,260,000
3. Topic: Unhedged foreign currency transactions, hedges of import and forecasted

transactions
LO 2, 4, 6
Following are exchange rates for the euro (U.S. $/€) . Import Express is a U.S. company whose
accounting year ends on December 31.
Forward rate for

May 31, 2011
delivery
Spot rate
November 30, 2010 $ 1.25 $ 1.30
December 31, 2010 1.28 1.32
May 31, 2011 1.26 1.26
Required
Answer the following questions.
a. On November 30, 2010, Import Express takes delivery of merchandise on credit from an Italian
supplier for €1,000. It pays for the merchandise on May 31, 2011. It sells the inventory to a
U.S. customer during 2011. What are the correct amounts that will appear on Import Express’
financial statements for each of the following items?
i. Accounts payable, December 31, 2010 balance sheet
ii. Cost of goods sold, 2011 income statement
iii. Foreign exchange loss, 2010 income statement
b. On November 30, 2010, Import Express takes delivery of merchandise on credit from an Italian
supplier for €1,000. On the same day, it agrees to buy €1,000 (forward purchase) for delivery
on May 31, 2011. Import Express closes the forward on May 31 and pays for the merchandise.
It sells the inventory to a U.S. customer during 2011. What are the correct amounts that will
appear on Import Express’ financial statements for each of the following items?
i. Investment in forward contract, December 31, 2010 (asset)
ii. Loss on forward contract, 2011
Gain on accounts payable, 2011
90
91
c. On November 30, 2010, Import Express forecasts that it will need to buy merchandise for
€1,000 from an Italian supplier at the end of May, 2011. It plans to pay for the merchandise as
soon as it is delivered. On November 30, 2010, Import Express agrees to buy €1,000 (forward
purchase) for delivery on May 31, 2011. The forward contract qualifies as a cash flow hedge of
the forecasted purchase of merchandise. The merchandise is actually delivered on May 31,
2011. Import Express closes the forward and immediately pays the supplier. The merchandise
is subsequently sold to a U.S. customer later in 2011. Make the journal entries necessary to
record these events:
i. December 31, 2010: Adjust the investment in forward contract.
ii. May 31, 2011:
(1) Adjust the investment in forward contract.
(2) Close out the forward contract.
(3) Take delivery of the merchandise and pay for it.
iii. Record cost of sales for 2011.
ANS:
a. Entries (not required):
11/30
Inventory 1,250
12/31
Exchange loss 30
Accounts payable 30
5/31
Accounts payable 20
Exchange gain 20

Cash 1,260
i. Accounts payable, December 31, 2010 balance sheet $1,280

ii. Cost of goods sold, 2011 income statement $1,250
ii. Exchange loss, 2010 income statement $ 30
92
b. Entries (not required):
11/30
Inventory 1,250
12/31
Exchange loss 30
Accounts payable 30
Exchange gain 20
5/31
Accounts payable 20
Exchange gain 20
Exchange loss 60
Foreign currency 1,260
Cash 1,300
i. Investment in forward contract, December 31, 2010 (asset) $20

ii. Loss on forward contract, 2011 $60
Gain on accounts payable, 2011 $20
93
c. i.
ii. (1)
(2)

Cash 1,300
(3)
Inventory 1,260
iii.

Inventory 1,260
94
4. Topic: Forward purchase, cash flow hedge that becomes a fair value hedge
LO 4, 5, 6
1Use the following information on exchange rates for the euro to answer the question below.
Forward
rate for
4/30/12
Spot delivery
rate
October 1, 2011 $1.45 $1.48
December 31, 2011 1.50 1.53
January 31, 2012 1.52 1.55
March 31, 2012 1.56 1.58
April 30, 2012 1.60 1.60
On October 1, 2011, a U.S. company forecasts that it will take delivery of merchandise from a supplier
in Portugal for €10,000,000 around the end of March, 2012, with payment expected to be made, in
euros, about one month later. The company closes its books on December 31. The following events
occur:
1. October 1, 2011: The company enters a forward purchase agreement for delivery of
€10,000,000 on April 30, 2012. This position qualifies as a hedge of the forecasted transaction
described above. No initial investment is required.
2. December 31, 2011: The company closes its books.
3. January 31, 2012: The company issues a purchase order to the supplier for €10,000,000 in
merchandise, to be delivered March 31, 2012.
4. March 31, 2012: The company takes delivery of the merchandise.
5. April 30, 2012: The company closes the forward contract and pays the supplier €10,000,000.
6. May 15, 2012: The company sells the merchandise to a U.S. customer for $22,500,000.
Required
Prepare the journal entries to record the above events on the indicated dates.
95
ANS:
December 31, 2011: End of year adjusting entry:
Investment in forward 500,000

Other comprehensive
income
500,000
January 31, 2012: Adjust the investment:

Other comprehensive
income
200,000
March 31, 2012: Adjust for the period January 31 - March 31, and take delivery of the
merchandise.

Other comprehensive
income
300,000
Exchange loss 300,000

Firm commitment 300,000
Other comprehensive income 300,000

Exchange gain 300,000
Inventory 15,300,000
Accounts payable 15,600,000
96
April 30, 2012: Adjust for the period March 31 to April 30, close the forward contract and pay the
supplier.

Other comprehensive
income
200,000


Foreign currency 16,000,000

Investment in forward 1,200,000
Cash 14,800,000

Cost of goods sold 14,800,000

97
LO 5
1Following is information on $/€ exchange rates:

Spot rate August 15, 2012
March 1, 2012 $1.50 $1.55
June 30, 2012 1.60 1.62
August 15, 2012 1.65 1.65
A U.S. company buys from suppliers in Germany, and pays the suppliers in euros. The U.S.
company’s accounting year ends June 30. 1On March 1, 2012, the company sends a purchase order
to a German supplier for €1,000,000 in merchandise, payable in euros, delivery to take place August
15, 2012. On the same day the company enters into a forward contract for delivery of €1,000,000 on
August 15. The forward qualifies as a hedge of a firm commitment. On August 15, the company closes
the forward contract, takes delivery of the merchandise, and pays the supplier. The company sells the
merchandise to its customers on August 31, 2012.
Required
What amounts will appear on the financial statements of the U.S. company for:
a. Investment in forward contract, June 30, 2012 balance sheet

b. Cost of goods sold, fiscal 2013 income statement
ANS:
a. €1,000,000 x ($1.62 - $1.55) = $70,000

b. Value of firm commitment = €1,000,000 x ($1.65 - $1.55) = $100,000 credit
Currency paid = $1,650,000 - firm commitment offset $100,000 = $1,550,000
98
LO 5
1On November 1, 2012, a U.S. company issues a purchase order to buy merchandise for €1,000,000.
The company expects to take delivery of the merchandise on January 10, 2008, and will pay the
supplier on March 1, 2013. To hedge its FX risk, on November 1, 2012 the company invests in a
forward contract for delivery of €1,000,000 on March 1, 2013. The company sells the merchandise to a
U.S. customer for $2,000,000 in cash on April 1, 2013. Assume the forward contract qualifies as a fair
value hedge of the firm commitment to buy merchandise.
Exchange rates for the euro ($/€) are below.
Forward rate for

November 1, 2012 $ 1.40 $1.42
December 31, 2012 1.41 1.43
January 10, 2013 1.44 1.435
March 1, 2013 1.45 1.45
Required
For each date below, prepare the necessary journal entries to record the events and/or adjustments
needed.
a. December 31, 2012 (end of year closing)

b. January 10, 2013 (takes delivery of merchandise)
c. March 1, 2013 (closes the forward and pays the bill)
d. April 1, 2013 (sells the merchandise to a U.S. customer). Assume the company uses the
perpetual inventory method.
99
ANS:
a. December 31, 2012


Rate changes from $1.42 to $1.43.
b. January 10, 2013

Exchange gain 5,000
Exchange loss 5,000

Inventory 1,425,000
0
c. March 1, 2013



Cash 1,420,00
0
100
0
d. April 1, 2013
Cash 2,000,000
Sales revenue 2,000,00
0

Inventory 1,425,00
0
101
7. Topic: Import and export transactions
LO 2
1Following is information on $/€ exchange rates:
Spot rate
November 1, 2013 $1.42
December 31, 2013 1.38
February 15, 2014 1.36
March 1, 2014 1.35
Required
Answer the following questions:
a. A U.S. company sells merchandise to customers in euro countries, with payment to be received
in euros. Sales totaling €1,000,000 occur on November 1, 2013. Payment is made on March 1,
2014. The U.S. company’s accounting year ends December 31. What amounts will appear on
the financial statements of the U.S. company for:
i. Sales revenue, 2013 income statement
ii. Accounts receivable, 12/31/13 balance sheet
iii. Exchange gain or loss, 2013 income statement
b. A U.S. company buys merchandise from suppliers in euro countries, payable in euros.
Purchases of €1,000,000 are made on November 1, 2013. The U.S. company pays the
suppliers on February 15, 2014. The U.S. company sells the merchandise to its customers on
March 1, 2014. The U.S. company’s accounting year ends December 31. What amounts will
appear on the financial statements of the U.S. company for:
i. Accounts payable, 12/31/13 balance sheet
ii. Exchange gain or loss, 2014 income statement
iii. Cost of goods sold, 2014 income statement
ANS:
a. i. €1,000,000 x $1.42 = $1,420,000

ii. €1,000,000 x $1.38 = $1,380,000
iii. €1,000,000 x ($1.38 - $1.42) = $40,000 loss
b. i. €1,000,000 x $1.38 = $1,380,000

ii. €1,000,000 x ($1.38 - $1.36) = $20,000 gain
iii. €1,000,000 x $1.42 = $1,420,000
102
8. Topic: Hedges of export transactions
LO 4
1A U.S. company sells merchandise to a Greek customer on February 1, 2010 for €1,000,000. The
customer pays the bill on May 1, 2010. To hedge foreign exchange risk, on February 1, 2010 the U.S.
company enters a forward sale contract for €1,000,000 with a May 1 delivery date. On May 1 the
company collects the €1,000,000 from the customer and closes the forward contract. Relevant rates
are as follows:
Spot 5/1 Forward

February 1, 2010 $1.345 $1.348
May 1, 2010 1.330 1.330
REQUIRED
Make the journal entries to record the following transactions, including appropriate adjusting entries:
a. February 1 sale to the Greek customer.
b. May 1 collection of the receivable and closing of the contract.
ANS:
a.

Sales revenue 1,345,00
0
b.

Accounts receivable 15,000


0
103
Cash 1,348,00
0
104
LO 5
On February 1, 2010, a U.S. company issues a purchase order to buy merchandise from a Greek
supplier for €1,000,000. On February 1, 2010 the U.S. company enters a forward purchase contract for
€1,000,000 with a July 1 delivery date. The forward qualifies as a hedge of the firm commitment to buy
the merchandise. On May 1, 2010, the company takes delivery of the merchandise. On July 1, 2010,
the company closes the forward and pays the bill. Relevant exchange rates are as follows:
7/1 forward
rate
Spot rate
February 1, 2010 $1.345 $1.350
May 1, 2010 1.340 1.344
July 1, 2010 1.330 1.330
REQUIRED
a. Make the journal entries to record the following transactions, including appropriate adjusting
entries:
i. May 1 delivery of merchandise.
ii. July 1 closing of forward contract and payment of bill.

b. Assume the U.S. company sells the merchandise to a U.S. customer for $1,600,000. What is
the reported gross margin (sales revenue minus cost of goods sold) on the sale?
ANS:
a. i.
Exchange loss 6,000


Exchange gain 6,000
Inventory 1,346,00
0
105
ii.



0
Cash 1,350,000

0
b. $1,600,000 - $1,346,000 = $254,000

LO 6
1A U.S. corporation purchases merchandise from a German supplier on a regular basis. On November
8, 2012, the corporation purchased €100,000 for delivery on March 8, 2013, in anticipation of an
expected purchase of merchandise for €100,000 at the beginning of March. The forward contract
qualifies as a hedge of a forecasted transaction. The corporation took delivery of the merchandise,
settled the forward contract, and paid the German supplier €100,000 on March 8, 2013. The
merchandise was subsequently sold on April 10, 2013 to a U.S. customer for $200,000. The
corporation’s accounting year ends on December 31. Relevant exchange rates are as follows:

Spot rate March 8, 2013
November 8, 2012 1.25 1.26
December 31, 2012 1.27 1.28
March 8, 2013 1.24 1.24
April 10, 2013 1.23 N/A
Required
a. Prepare the adjusting entry necessary to update the investment in forward at December 31,
2012.
b. Prepare the entries necessary to take delivery of the merchandise and close the forward on
March 8, 2013.
c. Prepare the entry necessary to record cost of goods sold on April 10, 2013.
106
ANS:
a.

Other comprehensive 2,000
income
b.


0
Cash 126,00
0
Inventory 124,00
0
0
c.
0
Inventory 124,00
0
income
107
11. Topic: Valuation of forward contracts, hedging entries
LO 3, 4, 6
1A U.S. company enters into the following forward contracts on October 15, 2011:
1. Agreement to sell 100,000,000 yen on January 15, 2012 at $0.0088

2. Agreement to buy 1,000,000 new shekels on February 15, 2012 at $0.221
Forward and spot rates for yen and shekels are as follows:
Forward rate
for 2/15/12
Forward rate Spot rate
delivery of new
for 1/15/12 for new
Spot rate shekels
delivery of shekels
for yen
yen
October 15, 2011 $ .0086 $ .0088 $.220 $ .221
December .0084 .0085 .222 .219
31,2011
The company’s accounting year ends December 31.
Required
a. How are the forward contracts valued on the company’s December 31, 2011 balance sheet?
For each contract, specify the amount and whether it is a current asset or a current liability.
b. Assume that the forward contract to sell yen is an effective hedge of a 100,000,000 yen
forecasted sale to customers in Japan. Make the adjusting entry for this contract at December
31, 2011.
c. Assume the forward contract to buy new shekels is an effective hedge of a
1,000,000 new shekel obligation currently on the company’s books. Make the adjusting entry for this
contract at December 31, 2011.
ANS:
a. Forward sale in yen: ($.0088 - $.0085) x 100,000,000 = $30,000 current asset

Forward purchase in new shekels: ($.221 - $.219) x 1,000,000 = $2,000 current liability
b.
income
c.
Exchange loss 2,000
108
109
LO 5
On March 1, 2011, a U.S. company issued a purchase order to a supplier in the Cayman Islands for
goods with a price of KYD 5,000,000. The goods will be delivered July 1, 2011, and payment will be
made on September 1, 2011. On March 1, 2011, the company purchased KYD 5,000,000 for delivery
September 1, 2011. The forward contract is an effective hedge of the firm commitment to purchase
goods from the Cayman Islands. The goods are delivered as expected on July 1, and the company
follows through on the forward contract and makes the payment to the supplier on September 1. The
company’s accounting year ends on December 31.
Spot and forward rates are as follows ($/KYD):

Spot Rate on September 1, 2011
March 1, 2011 $1.22 $1.21
July 1, 2011 1.21 1.20
September 1, 2011 1.19 1.19
Required
Answer the following questions regarding how the above information is reported on the company’s
financial statements:
a. What is the net hedging gain or loss for 2011?
b. Suppose the goods purchased from the Cayman Islands are sold to a U.S. customer for
$8,000,000. What is the gross margin (sales revenue less cost of goods sold) on the sale?
Show calculations clearly.
ANS:
a. Loss on forward: ($1.21 - $1.19) x 5,000,000 = $100,000 loss

Gain on firm commitment: ($1.21 - $1.20) x 5,000,000 = 50,000 gain
Gain on accounts payable: ($1.21 - $1.19) x 5,000,000 = 100,000 gain
Net $ 50,000 gain
b. Inventory is recorded as follows when the goods are delivered on July 1:
Inventory 6,100,00
0
0
The gross margin on the sale is:
110
Sales $8,000,000
Gross margin $1,900,000
111
13. Topic: Forward purchase, cash flow hedge that becomes a fair value hedge
LO 4, 5, 6
1A U.S. company purchases merchandise from a Hong Kong supplier on a regular basis. The following
events occur:
 October 1, 2012: The company purchased $H1,000,000 for delivery on May 1, 2013, in
anticipation of an expected payment of $H for a forecasted merchandise purchase.
 December 1, 2012: The company issued a purchase order for $H1,000,000 in merchandise
from the supplier.
 March 1, 2013: The company took delivery of the merchandise.
 May 1, 2013: The company closed the forward contract and paid the supplier.
 May 31, 2013: The company sold the merchandise to a U.S. customer for $200,000.
The company’s accounting year ends December 31.
Exchange rates ($/H) are as follows:
Forward rate for

delivery 5/1/13
Spot rate
October 1, 2012 $0.125 $0.127
December 1, 2012 0.127 0.129
December 31, 2012 0.128 0.131
March 1, 2013 0.131 0.1315
May 1, 2013 0.132 0.132
Required
Prepare the journal entries to record the above transactions, including necessary adjusting entries.
Assume the hedge qualifies for special hedge accounting.
112
ANS:
Adjusting entries at December 31, 2012:

To record increase in value of forward contract ($.127 to $.131)
Exchange loss 2,000

To record loss on firm commitment ($.129 to $.131)

Exchange gain 2,000
To reclassify other comprehensive income to income to match against loss on firm commitment.
March 1, 2013

To mark the forward to market ($.131 to $.1315)
Exchange loss 500

Firm commitment 500
To mark the firm commitment to market ($.131 to $.1315)

Exchange gain 500
To reclassify other comprehensive income to income to match against firm commitment loss.
Inventory 128,50
0
0
To record delivery of merchandise, adjusted for firm commitment balance.
113
114
May 1, 2013

To mark the forward to market ($.1315 to $.132)
Exchange loss 1,000

To mark accounts payable to market ($.131 to $.132)

Exchange gain 1,000
To reclassify other comprehensive income to income to match against accounts payable loss.

0
Cash 127,00
0
To close forward contract.

0
0
To pay the supplier.
May 31, 2013

0
Inventory 128,50
0
Note: Remaining other comprehensive income balance is $4,000 - $2,000 + $500 - $500 + $500 -
$1,000 = $1,500 gain.
115
14. Topic: Cash flow hedge accounting versus regular accounting
LO 3, 6
1Following is information on exchange rates for the euro:
Spot rate Forward rate for 4/30/12 delivery

October 1, 2011 $1.45 $1.48
December 31, 2011 1.50 1.53
January 31, 2012 1.52 1.55
March 31, 2012 1.56 1.58
April 30, 2012 1.60 1.60
On October 1, 2011, a U.S. company forecasts that it will buy merchandise from a supplier in Portugal for
€10,000,000 around the end of March, 2012, with payment expected to be made, in euros, about one
month later. The company closes its books on December 31. The following events occur:
1. October 1, 2011: The company enters a forward purchase agreement for delivery of
€10,000,000 on April 30, 2012. No initial investment is required.
2. December 31, 2011: The company closes its books.
3. January 31, 2012: The company issues a purchase order to the supplier for €10,000,000 in
merchandise, to be delivered March 31, 2012.
4. March 31, 2012: The company takes delivery of the merchandise.
5. April 30, 2012: The company closes the forward contract and pays the supplier €10,000,000.
6. May 15, 2012: The company sells the merchandise to a U.S. customer for $22,500,000.
Required
Fill in the schedule below, showing the amounts related to the above events that will be reported in the
company’s annual reports for 2011 and 2012. Show related journal entries in the next schedule. Show
liabilities and gains in parenthesis.
116
ANS:
Forward contract qualifies as

a hedge of the forecasted
The forward contract does not
transaction
qualify as a hedge
Account title
2011 2012 2011 2012
Investment in forward $ 500,000 -- $ 500,000 --
(balance sheet)
Other comprehensive (500,000) -- -- --
income (Balance sheet)
(Gains) and losses (income -- -- (500,000) $ (200,000)
statement)
(300,000)
(200,000)
400,000
$ (300,000)
-- $14,800,000 -- $15,600,000
Cost of goods sold (income
statement)
117
Forward contract is a qualified hedge Forward contract is not a qualified hedge
December 31
Exchange gain
OCI 500,000 500,000
118
January 31
Investment in forward 200,000 Investment in forward 200,000
OCI 200,000 Exchange gain

200,000
March 31
OCI 300,000
Exchange gain
Exchange loss 300,000 300,000
Firm commitment 300,000 --
OCI 300,000
Gain 300,000 --
Firm commitment 300,000 Inventory 15,600,000
A/P 15,600,000 A/P
15,600,000
April 30
OCI 200,000
Exchange gain
A/P 400,000
200,000
OCI 400,000
A/P
Foreign currency 16,000,000 400,000
Cash 14,800,000 --
Investment in for. 1,200,000

A/P 16,000,000 Foreign currency 16,000,000
Foreign currency 16,000,000 Cash

14,800,000
Investment in for. 1,200,000
May 15
A/P 16,000,000
CGS 14,800,000
Foreign currency
OCI 500,000 16,000,000
CGS 15,600,000
Inventory
15,600,000
119
15. Topic: Cash flow hedge accounting versus regular accounting
LO 3, 6
Following are exchange rates for the Canadian dollar.
Forward rate for March 31,

2012 delivery
Spot rate
October 31, 2011 $ 0.80 $ 0.81
December 31, 2011 0.84 0.86
March 31, 2012 0.82 0.82
A U.S. company enters a forward contract on October 31, 2011 to hedge a forecasted purchase of
merchandise for C$1,000,000 on March 31, 2012. On March 31 it takes delivery of the merchandise,
closes the forward and pays for the merchandise. It sells the merchandise in May. The company’s
accounting year ends December 31.
Required
What are the balances for the following accounts, assuming the forward contract qualifies as a hedge of
the forecasted transaction for the period October 31, 2011 to March 31, 2012, and also if the forward
contract does not qualify as a hedge?
a. Other comprehensive income balance, December 31, 2011

b. Gain/loss on forward contract, 2011 income statement
c. Gain/loss on forward contract, 2012 income statement
d. 2012 cost of goods sold
ANS:
Qualifies as Does not qualify

hedge
Other comprehensive income, December
31, 2011 (gain)
$ 50,000 $ 0
2011 income statement
gain on forward contract 0 50,000
2012 income statement
loss on forward contract 0 40,000
2012 cost of goods sold 810,000 820,000
120
16. Topic: Hedge of firm commitment, import transaction, speculation
LO 2, 5, 7
Electronic Importers, a U.S. company, has the following outstanding balances as of December 31,
2011, its accounting year-end.
Forward purchase contract dated December 1, 2011 for 20,000,000 yen to hedge a firm commitment
to purchase computer hardware for 20,000,000 yen in 90 days ending on March 1, 2012.
Account payable for 70,000,000 yen for unpaid merchandise acquired on December 16, 2011 and due
on January 15, 2012.
Forward sale contract dated December 16, 2011 for 30,000,000 yen to speculate in exchange rate
changes and due on January 15, 2012.
Exchange rates quoted in the U.S. for Japanese yen are:
12/1/11 12/16/11 12/31/11 1/15/12 3/1/12

Spot rate $.00620 $.00610 $.00600 $.00593 $.00580
90-day forward .00630 .00620 .00610 .00600 .00590
60-day forward .00620 .00610 .00603 .00590 .00580
30-day forward .00610 .00600 .00590 .00580 .00570
15-day forward .00615 .00605 .00595 .00585 .00575
Required
a. Calculate the gain or loss on Electronic Importers' 2011 income statement due to the above
items. Specify the amount and whether it is a gain or loss.
b. Calculate the balances at which the forward purchase contract and the forward sale contract
would be reported in the December 31, 2011 balance sheet.
c. At what amount (U.S. dollars) should the computer hardware be valued on March 1, 2012?
121
ANS:
a. Forward purchase contract: no income effect due to offsetting gain and loss on contract and firm
commitment.
Accounts payable 70,000,000 x ($.00610 - $.00600) = $7,000 gain

Forward sale 30,000,000 x ($.00600 - $.00595) = 1,500 gain
$8,500 gain
b. Forward purchase contract:

($.0063 - $.00603) x 20,000,000 = $5,400 current liability
Forward sale contract:

($.006 - $.00595) x 30,000,000 = $1,500 current asset
c.
($.0058 x 20,000,000) = $116,000
Plus firm commitment balance:
($.0063 - $.0058) x 20,000,000 10,000
Hardware balance, 3/1/12 $126,000
122
17. Topic: Import transactions, hedge of firm commitment, hedge of forecasted transaction,
speculation
LO 2, 5, 6, 7
Each of the following situations is independent of the others. Acme Importers is a U.S. company with a
December 31 year-end. Use the following information on exchange rates (US$/$Canadian) to answer
each question.
Forward rate
for delivery
on 2/1/13
Spot rate
September 1, 2012 $.80 $.82
October 1, 2012 .78 .79
December 31, 2012 .75 .74
February 1, 2013 .69 .69
Required
For each situation, (1) make the journal entries necessary to record the events, including year-end
adjustments, and (2) calculate the effect on Acme's income in the year 2012, and in the year 2013.
Show the amounts and whether they are gains or losses.
a. On September 1, 2012 Acme Importers agrees to buy merchandise from Montreal Suppliers.
Delivery will take place on October 1, 2012, and Acme will pay Montreal Suppliers C$5,000 on
February 1, 2013.
b. On September 1, 2012, Acme Importers makes a firm commitment to buy merchandise from
Montreal Suppliers. Delivery will take place on October 1, 2012, and Acme will pay Montreal
Suppliers C$5,000 on February 1, 2013. On October 1, 2012, Acme enters into a forward
purchase contract with ABC Exchange Dealers for the purchase of C$5,000, to be delivered
February 1, 2013.
c. On September 1, 2012, Acme Importers makes a firm commitment to buy merchandise from
Montreal Suppliers. Delivery will take place on October 1, 2012, and Acme will pay Montreal
Suppliers C$5,000 on February 1, 2013. On September 1, 2012, Acme enters into a forward
purchase contract with ABC Exchange Dealers for the purchase of C$5,000, to be delivered
February 1, 2013. The merchandise remains in Acme's inventory as of December 31, 2013.
d. The CFO at Acme Importers believes that the U.S. dollar will continue to strengthen with respect
to the Canadian dollar. On October 1, 2012, he enters into a speculative forward sale contract
with ABC Exchange Dealers for delivery of C$5,000 on February 1, 2013.
e. On September 1, 2012, Acme Importers forecasts that it will buy merchandise from a Canadian
supplier. Delivery and payment of C$5,000 is expected to take place on October 1, 2012. On
September 1, 2012, Acme enters into a forward purchase contract with ABC Exchange Dealers
for the purchase of C$5,000 for $0.76, to be delivered October 1, 2012. The merchandise
purchase occurs as forecasted, and the merchandise remains in Acme’s inventory as of
December 31, 2013.
123
ANS:
1a.
10/1 Merchandise 3,900
(5,000 x $.78)
12/31 Accounts payable 150

10/1
Exchange gain 150
[($.78 - $.75) x 5,000]

Exchange gain 300
[($.75 - $.69) x 5,000]
2/1 Accounts payable 3,450

Cash 3,450
(5,000 x $.69)
b.

Exchange gain 150
12/31 Exchange loss 250

[($.79 - $.74) x 5,000]

Exchange gain 300

[($.74 - $.69) x 5,000]
2/1 Foreign currency 3,450

Cash 3,950
2/1 Accounts payable 3,450

124
c.
[($.82 - $.79) x 5,000]
10/1 Firm commitment 150

Exchange gain 150

10/1 Merchandise 150

Firm commitment 150


Exchange gain 150

Accounts payable 300
2/1
Exchange gain 300

Cash 3,950
2/1
125
d.
12/31 Investment in forward 250

Exchange gain 250
[($.79 - $.74) x 5,000]

Exchange gain 250
[($.74 - $.69) x 5,000]

Cash 3,450
Cash 3,950
2/1
e.

Other comprehensive
income 100
[($.78-.76) x 5,000]

Cash 3,800
Merchandise 3,900
10/1
2. Income effects:
2012 2013
(a) $150 gain $300 gain
(b) 100 loss 50 gain
(c) 100 loss 50 gain
(d) 250 gain 250 gain
(e) -0- -0-
126
18. Topic: Borrowing in foreign currency
LO 2
A U.S. company purchases a 60-day certificate of deposit from a German bank on October 15. The
certificate has a face value of €10,000,000, costs $13,800,000 (the spot rate is $1.38/€ on October 15),
and pays interest at an annual rate of 8 percent. On December 14, the certificate of deposit matures and
the company receives principal and interest due to it. The spot rate on December 14 is $1.40/€. The
average spot rate for the period October 15 - December 14 is $1.39/€.
Required
Prepare all necessary journal entries to record the above events on the U.S. company's books.
ANS:
10/15
Temporary investments 13,800,000

Cash 13,800,000
12/14
Temporary investments 200,000

$200,000 = ($1.40 - $1.38) x €10,000,000.

Temporary
investments
14,000,000
Interest income 186,667
$186,667 = (10,000,000 x 8% x 2/12) x $1.40
127
19. Topic: Speculation in forward contracts
LO 7
On November 1, 2013, a U.S. company thinks the exchange rate for the euro will fall, so it enters into a
forward contract in the amount of €1,000,000, for delivery on March 15, 2014. This is a speculative
contract. The company’s accounting year ends December 31. The company closes the contract on
February 1, 2014. Exchange rates are as follows ($/€):
Forward rate for

November 1, 2013 $ 1.42 $ 1.43
December 31, 2013 1.46 1.45
February 1, 2014 1.47 1.48
March 15, 2014 1.50 1.50
Required
a. Does the company enter a forward purchase or a forward sale contract? Explain.
b. Prepare the journal entries necessary on December 31, 2013 and February 1, 2014 to record
the above events.
ANS:
a. A forward sale locks in the selling price. If the rate falls, as the company expects, it will gain by
buying euros at the lower price and selling at the higher contract price.
b. December 31, 2013
Loss 20,000
To adjust the forward contract to fair value; $20,000 = ($1.45 - $1.43) x €1,000,000.
February 1, 2014
Loss 30,000
To adjust the forward contract to fair value; $30,000 = ($1.48 - $1.45) x €1,000,000.
The company closes the forward by entering a forward purchase for delivery on March 15, 2014, at
$1.48/€. So the company sells at $1.43 and buys at $1.48, for a net cash outflow of ($1.48 - $1.43) x
€1,000,000 = $50,000.

Cash 50,000
To close the forward contract on February 1, 2014.
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20. Topic: IFRS for hedging forecasted transactions
LO 8
On February 15, 2011, an Italian company, with a June 30 year-end, enters a forward purchase
contract for $1,000,000 to be delivered on August 1, 2011. The contract hedges a forecasted purchase
of equipment. The forward is closed and the equipment purchased on August 1. The equipment has a
2-year life, and is straight-line depreciated. Following is information on exchange rates (€/$):
Forward rate for August 1,

2011 delivery
Spot rate
February 15, 2011 €0.80 €0.81
June 30, 2011 0.74 0.76
August 1, 2011 0.72 0.72
The company follows IFRS and uses the basis adjustment approach to reporting cash flow hedges.
Required
Prepare the journal entries to record the following events:
a. June 30, 2011 adjusting entry

b. August 1, 2011 adjusting entries and transactions
c. June 30, 2012 adjusting entry for the equipment
d. If the company followed U.S. GAAP, how would the June 30, 2012 entry differ?
129
ANS:
a. June 30, 2011

To adjust the forward contract to fair value; €50,000 = (€.81 - €.76) x $1,000,000.
b. August 1, 2011

To adjust the forward contract to fair value; €40,000 = (€.76 - €.72) x $1,000,000.

0
Cash 810,00
0
To close the forward contract.
Equipment 720,00
0
0
To purchase the equipment.
Equipment 90,000
To adjust the equipment for the accumulated loss on the forward.
c. June 30, 2012
Depreciation expense 371,25

0
Equipment, net 371,25
0
To record depreciation expense for fiscal 2012; €371,250 = (€810,000/2) x 11/12.
d. June 30, 2012

0
Equipment, net 330,00
0
To record depreciation expense for fiscal 2012; €330,000 = (€720,000/2) x 11/12.

To reclassify other comprehensive income as an adjustment of depreciation expense for fiscal
2012; €41,250 = (€90,000/2) x 11/12.
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1. The holder of a long forward contract has:
a. the option to buy the underlying asset at a fixed price on a fixed future date
b. the option to sell the underlying asset at a fixed price on a fixed future date
c. the obligation to buy the underlying asset at a fixed price on a fixed future date
d. the obligation to sell the underlying asset at a fixed price on a fixed future date
e. None of these answers are correct.

ANS: C DIF: Easy REF: 4.2 TOP: Forward Contracts
MSC: Factual

2. The holder of a short forward position has:
a. the option to buy the underlying asset at a fixed price on a fixed future date
b. the option to sell the underlying asset at a fixed price on a fixed future date
c. the obligation to buy the underlying asset at a fixed price on a fixed future date
d. the obligation to sell the underlying asset at a fixed price on a fixed future date

ANS: D DIF: Easy REF: 4.2 TOP: Forward Contracts
MSC: Factual

3. Shaq buys a futures contract today. Which of the following is true?
a. Shaq agrees to buy the asset at a fixed price at some future date.
b. Shaq will get dividends on the underlying asset.
c. Shaq acquires voting rights on the asset.
d. Shaq will have to return the asset when closing out his position.

ANS: A DIF: Easy REF: 4.2 TOP: Forward Contracts
MSC: Factual

4. Which of the following is INCORRECT?
a. The buyer and seller in a forward contract agree to trade a commodity on some later delivery date at a fix
delivery (forward) price.
b. Forwards are zero net supply contracts.
c. Forward trading is a zero-sum game.
d. Forward contracts have significant counterparty risk.
e. Forward contracts are regulated by the Commodity Futures Trading Commission.

ANS: E DIF: Easy REF: 4.2 TOP: Forward Contracts
MSC: Factual

 A US company has bought a machine worth 3 million euros from a German manufacturer with
payment due in three months. The treasurer finds that DeutscheUSA (a fictitious name), a large
commercial bank, bids euros for $1.5000 and offers euros for $1.5010 in three months’ time. He readily
agrees and locks in that price.
131
 Suppose DeutscheUSA would like to hedge its trade. It finds that a German importer hoping to buy 2
million euros worth of computer parts from the United States in three months’ time. They also agree to
trade.

5. What is the price risk exposure remaining for DeutscheUSA?
a. $1 million US dollars today
b. $2 million US dollars in three months’ time
c. 3 million euros today
d. 1 million euros in three months’ time

ANS: D DIF: Easy REF: 4.3
TOP: The Over-the Counter Market for Trading Forwards MSC: Applied

6. What is DeutscheUSA’s profit and risk exposure after three months time?
a. a profit of $1,000 US dollars plus risk exposure on $2 million dollars
b. a profit of $2,000 US dollars
c. a profit of $2,000 US dollars plus risk exposure on $1 million dollars
d. a profit of $2,000 US dollars plus risk exposure on 1 million euros

ANS: D DIF: Moderate REF: 4.3
TOP: The Over-the Counter Market for Trading Forwards MSC: Applied

7. Which statement is INCORRECT about futures contracts?
a. Futures contracts are regulated.
b. Futures require counterparties to know each other.
c. Futures trades require margins.
d. Performance of futures contracts are guaranteed by a clearinghouse.
e. Most futures contracts are closed out before maturity.

ANS: B DIF: Easy REF: 4.4 TOP: Futures Contracts
MSC: Factual

8. The main distinction between a forward and a futures contract is:
a. a forward contract has a final cash flow, while a futures contract has daily cash flows
b. a forward contract requires no collateral, while a futures contract requires traders to post margins
c. a forward trade is usually closed out early, while a futures trade usually ends with physical delivery
d. a forward trade requires cash settlement, while a futures trade does not require this
e. minor—they are the same contracts

ANS: A DIF: Moderate REF: 4.4 TOP: Futures Contracts
MSC: Factual

9. Which of the following is NOT a job performed by a futures clearinghouse?
132
a. guaranteeing contract performance
b. providing price support in case of a market crash
c. resolving small disputes among traders regarding an executed trade
d. recording and recognizing trades
e. checking that trades match

ANS: B DIF: Easy REF: 4.5
TOP: Exchange Trading of a Futures Contract MSC: Factual

10. Settlement of a futures trade:
a. takes place on the following trading day
b. takes place five days after a trade is executed
c. have real time, instant settlement due to advances in technology
d. takes place on every trading day until the contract is closed out or it matures


11. The open interest on a futures contract is:
a. the sum of both the outstanding long and short positions
b. the total of all hedged positions
c. the total number of contracts that got traded during the day
d. the number of contracts in which traders have shown trading interest by submitting a bid or an ask price q
e. the total of all outstanding contracts

ANS: E DIF: Easy REF: 4.5

12. Suppose that July gold futures just become eligible for trading. Tim buys 20 of those contracts from
Ned. Next, he sells 10 contracts to Mary. Finally, Ned buys 10 contracts from Tim. As a result of these
three trades:
a. trading volume is 20 contracts and open interest rate is 20 contracts
b. trading volume is 30 contracts and open interest rate is 15 contracts
c. trading volume is 40 contracts and open interest rate is 10 contracts
d. trading volume is 40 contracts and open interest rate is 20 contracts

ANS: C DIF: Moderate REF: 4.5
TOP: Exchange Trading of a Futures Contract MSC: Applied

13. You manufacture silver jewelry. To hedge some of your risks, you can:
a. go long silver futures to hedge input price risk
b. go short silver futures to hedge input price risk
133
c. go long silver futures to hedge output price risk
d. do nothing with silver futures
e. do nothing as silver futures do not trade

ANS: A DIF: Easy REF: 4.6
TOP: Hedging with Forwards and Futures MSC: Applied

14. Golddiggers, Inc., mines gold and sells refined, pure gold in the world market. To hedge some of its
price risk, the company can:
a. short gold futures to hedge input risk
b. long gold futures to hedge output risk
c. short gold futures to hedge output risk
d. long gold futures to hedge input risk
e. There’s no suitable contract that Golddiggers can use for hedging purposes.

ANS: C DIF: Easy REF: 4.6

15. Suppose you trade futures contracts on precious metals. Which of the following risks are you are
exposed to?
a. credit risk, legal risk, liquidity risk, and market risk
b. no credit risk; legal risk, liquidity risk, and market risk
c. no credit risk or legal risk; liquidity risk and market risk
d. no credit risk, legal risk, or liquidity risk; market risk
e. no credit risk, legal risk, liquidity risk, or market risk

CHAPTER 7: Financial Engineering and Swaps

MULTIPLE CHOICE

1. The holder of the following security gives an option to the issuer:
a. a callable bond
b. a convertible bond
c. an employee stock option
d. a stock
e. a warrant

TOP: The Build and Break Approach MSC: Factual

2. The holder of the following security gets an additional option embedded within the bond:
a. a callable bond
b. a convertible bond
134
c. an employee stock option
d. a stock
e. a warrant

TOP: The Build and Break Approach MSC: Factual

3. Hybrids:
a. are bonds with repayment pegged to the stock’s price
b. are derivative securities that combine swaps with options
c. are derivative securities that combine calls with puts
d. are derivatives whose payoffs are tied to exchange rates
e. are combinations of options and futures

ANS: A DIF: Easy REF: 7.3 TOP: Financial Engineering
MSC: Factual

Your company is planning to buy euros in six months time. The spot price is $1.25 per euro. Boldman
Bankers Inc. (fictitious name) designs a “fancy derivative” that provides protection against an appreciation in
the euro, but it also limits your benefits if the euro declines. After six months, by the terms of this “range
forward,” (1) if the spot exchange rate for the euro is above $1.30, then you pay $1.30; (2) if the spot
exchange rate for the euro is below $1.20, then you pay $1.20; and (3) if the spot exchange rate lies
between this range, then you buy euros at the prevailing market price.

4. Your cousin, who is studying derivatives at college, says “This is no big deal,” and breaks down this
range forward into basic building blocks. His breakdown is:
a. long zero-coupon bond with a face value $1.20, long call with strike price $1.20, and short call with strike
$1.30
b. long zero-coupon bond with a face value $1.20, short call with strike price $1.20, and short call with strike
$1.30
c. short zero-coupon bond with a face value $1.20, short call with strike price $1.20, and long call with strike
$1.30
d. short zero-coupon bond with a face value $1.30, short call with strike price $1.20, and long call with strike
$1.30
e. long zero-coupon bond with a face value $1.30, short call with strike price $1.20, and short call with strike
$1.30

ANS: A DIF: Moderate REF: 7.3 TOP: Financial Engineering
MSC: Applied

5. Another cousin, who is also studying derivatives at university, said your portfolio must include a long
spot position in euros, because you are planning to buy euros. Her breakdown is:
a. long spot, short put with strike price $1.30, and short call with strike price $1.20
b. short spot, long put with strike price $1.30, and short call with strike price $1.20
c. long spot, long put with strike price $1.20, and short call with strike price $1.30
d. short spot, long put with strike price $1.20, and short call with strike price $1.30
e. long spot, long put with strike price $1.30, and long call with strike price $1.20

135

ANS: C DIF: Moderate REF: 7.3 TOP: Financial Engineering
MSC: Applied

6. The following is NOT a feature of plain vanilla interest rate swap contracts:
a. interest rate risk
b. counterparty risk
c. early termination of the swap with the consent of all counterparties
d. existence of swap facilitators
e. the Swap Trading Corporation (STC) overseeing all swap transactions

ANS: E DIF: Easy REF: 7.4 TOP: An Introduction to Swaps
MSC: Factual

7. A typical commodity swap involves:
a. a payment of the difference between two different commodities’ prices on the expiration date
b. an exchange of a fixed payment for the daily average of a commodity’s price over a time period
c. an exchange of a fixed payment for a floating payment that depends on one of the counterparty’s fluctuat
commodity need during the month
d. payments in two different currencies

TOP: Applications and Uses of Swaps MSC: Factual

8. The following is NOT a characteristic feature of a plain vanilla interest rate swap:
a. cash flows in the same currency
b. counterparty risk
c. exchange of principal at the beginning and at the end
d. a net payment by one of the parties
e. notional principal

ANS: C DIF: Easy REF: 7.6 TOP: Types of Swaps
MSC: Factual

9. A plain vanilla forex swap does NOT involve which of the following?
a. exchange of principal at the beginning
b. exchange back of principal along with interest payments
c. cash flows in different currencies
d. cash flows at intermediate dates
e. more than two counterparties

ANS: D DIF: Easy REF: 7.6 TOP: Types of Swaps
MSC: Factual

10. A plain vanilla currency swap does NOT involve which of the following?
136
a. an exchange of equivalent amounts in two different currencies on the start date
b. a net payment by one of the counterparties
c. cash flows in different currencies at intermediate dates
d. exchange of interest payments on these two currency loans on intermediate dates
e. repayment of the principal amounts on the ending date along with the final period’s interest payments

ANS: B DIF: Easy REF: 7.6 TOP: Types of Swaps
MSC: Factual

Americana Bank has $200 million of excess funds and Britannia Bank has £100 million of excess funds in
pound sterling. The spot exchange rate SA is $2 per pound sterling. They enter into a currency swap today
that has a tenor of two months. The annual risk-free simple interest rates are i = 4 percent in the United
States and iE = 5 percent in the United Kingdom. Cash flows are exchanged at the end of each month.

11. The currency swap begins today with:
a. Americana paying $200 million to Britannia and receiving £200 million in return
b. Americana paying $200 million to Britannia and receiving £100 million in return
c. Americana paying $100 million to Britannia and receiving £100 million in return
d. currency swaps have notional principal—no exchange of cash flows takes place today

ANS: B DIF: Easy REF: 7.6 TOP: Types of Swaps
MSC: Applied

12. At the end of one month:
a. Americana pays £0.4167 million to Britannia and receives $0.6667 million in return
b. Americana pays £0.8333 million to Britannia and receives $0.3333 million in return
c. Americana pays £0.4167 million to Britannia and receives $0.3333 million in return
d. Americana pays £0.8333 million to Britannia and receives $0.6667 million in return

ANS: A DIF: Easy REF: 7.6 TOP: Types of Swaps
MSC: Applied

13. After two months, the swap ends with the following transaction:
a. Americana pays £100 million to Britannia and receives $200 million in return
b. Americana pays £100.8333 million to Britannia and receives $201.3333 million in return
c. Americana pays £100.4167 million to Britannia and receives $200.6667 million in return
d. Americana pays £100.4167 million to Britannia and receives $201.3333 million in return

ANS: C DIF: Easy REF: 7.6 TOP: Types of Swaps
MSC: Applied

137
14. Consider a swap between Americana Auto Company (which wants to build an auto plant in the
United Kingdom) and Britannia Bus Corporation (which wants to build an auto plant in the United States;
both fictitious names):
 The automakers enter into a swap with a three-year term on a principal of $200 million.
 The spot exchange rate SA is $2 per pound. Americana raises 100 ´ 2 = $200 million and gives it to
Britannia, who, in turn, raises £100 million and gives it to Americana.
 Americana pays Britannia at the coupon rate of 4 percent per year on £100 million and Britannia pays
Americana at the coupon rate of 5 percent per year on $200 million for three years.
Now assume that the companies make payments every six months: the swap ends after six semiannual
payments, and the principals are handed back after three years.
Zero-Coupon Bond Prices in the United States (Domestic Country) and the
United Kingdom (Foreign Country)
Time to Maturity (in US (Domestic) Zero-Coupon Bond Prices UK (Foreign or European) Zero-Co
Years) (in Dollars) Bond Prices (in Pounds Sterling)
0.5 B(0.5) = $0.99 B(0.5)E = £0.98
1 B(1) = $0.97 B(1)E = £0.96
1.5 B(1.5) = $0.95 B(1.5)E = £0.93
2 B(2) = $0.93 B(2)E = £0.91
2.5 B(2.5) = $0.91 B(1.5)E = £0.88
3 B(3) = $0.88 B(3)E = £0.85
Using zero-coupon bond prices (maturing every six months) given above, one can compute the dollar value
of this foreign currency swap to Americana as:
a. $8.96
b. $12.11 million
c. $18.22 million
d. $108.13

ANS: B DIF: Difficult REF: 7.6 TOP: Types of Swaps
MSC: Applied

15. A credit default swap (CDS) on a bond with physical delivery is:
a. a term insurance policy, with a regular premium payment, that pays the face value of the bond if there is a
credit event
b. a term insurance policy, with a regular premium payment, that pays the value of the firm’s equity if there i
credit event
c. a term insurance policy, with a one time up-front premium, that pays the face value of the bond if there is
credit event
d. a term insurance policy, with a one time up-front premium, that pays the value of the firm’s equity if there
credit event

ANS: A DIF: Easy REF: 7.6 TOP: Types of Swaps
MSC: Factual

16. Suppose that you want to short BUG’s outstanding ten-year, 5 percent coupon bond, but you cannot
find anyone willing to lend you the bond (to short). Given that US Treasuries and CDS trade, you can
create a short position in BUG’s bond by:
a. going long a ten-year CDS on BUG
138
b. going short a ten-year CDS on BUG
c. going long a ten-year CDS on BUG and buying a ten-year US Treasury bond
d. going long a ten-year CDS on BUG and shorting a ten-year US Treasury bond
e. going short a ten-year CDS on BUG and shorting a ten-year US Treasury bond

ANS: D DIF: Difficult REF: 7.6 TOP: Types of Swaps
MSC: Applied
CHAPTER 13: Futures Hedging

MULTIPLE CHOICE

1. Which of the following statements related to a corporation hedging in the real world is INCORRECT?
a. Corporations should not hedge because a shareholder can always replicate such policies themselves tra
related securities.
b. In case a decision is made to hedge, corporations can do it at lower transaction costs than shareholders
c. A company hedge is often better than a shareholder’s hedge because companies can dedicate competen
personnel to hedging.
d. A company can hedge by issuing a whole range of securities that individuals cannot create on their own.
e. A company can hedge for strategic reasons that may lie beyond an ordinary shareholder’s knowledge.

ANS: A DIF: Moderate REF: 13.2 TOP: To Hedge or Not to Hedge
MSC: Factual

2. Which of the following statements related to the benefits of corporate hedging using forward and
futures contracts is INCORRECT?
a. Hedging can enable the locking-in of stable prices and facilitate the planning of production and marketing
activities with greater certainty.
b. Hedging can permit forward pricing of products.
c. Hedging can facilitate the raising of capital.
d. Hedging can reduce the risk of default and financial distress.
e. Hedging can enable a firm to develop a diverse product line.

ANS: E DIF: Easy REF: 13.2 TOP: To Hedge or Not to Hedge
MSC: Conceptual

3. An airlines company is unlikely to use the following derivative for risk management:
a. a commodity swap
b. a credit default swap
c. an interest rate swap
d. an oil futures contract
e. an option on oil futures contract

ANS: B DIF: Easy REF: 13.2 TOP: To Hedge or Not to Hedge
MSC: Conceptual

4. Which of the following statements related to the hedging of fuel price risk by airlines is INCORRECT?
139
a. Fuel is a major cost of the airline business and it can range from 10 percent (in good times) to more than
percent (in bad times) of average expenses.
b. All airlines hedge price risk of between 75 to 100 percent of their fuel purchase.
c. The amount of fuel needs hedged by the airlines has ranged from zero to over 75 percent.
d. What Southwest Airlines characterizes as their successful derivatives hedging program was some combin
of hedging and speculation that worked well for a time.
e. An airline’s decision to charge for checked-in baggage is a natural hedge, because loss of revenue from
customers is offset by money received from the fees and making airplanes lighter (which are cheaper to f

ANS: B DIF: Moderate REF: 13.2 TOP: To Hedge or Not to Hedge
MSC: Factual

Goldmines Inc. (fictitious name) makes a pretax profit of $150 million when gold prices increase (which
happens with probability 0.5) but zero otherwise. Alternatively, the company can hedge with gold futures and
have a known profit of $70 million.

5. Assuming a tax rate of 30 percent, the expected after-tax profit for an unhedged firm and the after-tax
profit for a hedged firm, respectively, are:
a. $52.5 million for the unhedged firm and $49 million for the hedged firm
b. $50 million for the unhedged firm and $49 million for the hedged firm
c. $50 million for the unhedged firm and $52.1 million for the hedged firm
d. $52.5 million for the unhedged firm and $52.1 million for the hedged firm

ANS: A DIF: Moderate REF: 13.2 TOP: To Hedge or Not to Hedge
MSC: Applied

6. Suppose that Goldmines has accumulated losses totaling $30 million. It can deduct this loss from this
year’s profit and thus lower its tax burden. If unutilized, this opportunity disappears. Assuming a tax rate
of 30 percent, the expected after-tax profit for an unhedged firm and the after-tax profit for a hedged firm,
respectively, are:
a. $50 million for the unhedged firm and $49 million for the hedged firm
b. $55 million for the unhedged firm and $54 million for the hedged firm
c. $57 million for the unhedged firm and $59 million for the hedged firm
d. $57 million for the unhedged firm and $58 million for the hedged firm

ANS: D DIF: Difficult REF: 13.2 TOP: To Hedge or Not to Hedge
MSC: Applied

7. The difference between the futures and the spot price is known as:
a. the basis
b. the depth
c. liquidity
d. the strike
e. the spread

140

ANS: A DIF: Easy REF: 13.3 TOP: Hedging with Futures
MSC: Factual

8. Let the spot price of gold today be $1,500 per ounce. Jewelry maker Jewelrygold Inc. sets up a
buying hedge by going long gold futures. The basis is –$50 today and –$5 on the day the company lifts
the hedge by buying gold in the spot market and selling the futures. The company’s effective buying
price for gold is:
a. $1,505
b. $1,545
c. $1,550
d. $1,555

ANS: B DIF: Moderate REF: 13.3 TOP: Hedging with Futures
MSC: Applied

9. Suppose that you buy oat to make breakfast cereals and trade oat futures to hedge input price risk.
Your factories are located far from places where oat may be delivered as per contract terms. Your
assistant prepares for you the following table based on price changes for oat spot and futures.

Futures Contracts Correlation of Price Changes Variance of Basis
Previous month futures 0.79 3.20
Spot month futures 0.89 0.88
Next month futures 0.87 0.99
Sixth month futures 0.71 9.80

Which contract would you choose to obtain the best hedge?
a. previous month futures
b. spot month futures
c. next month futures
d. sixth month futures
e. cannot form a judgment based on above information

ANS: C DIF: Moderate REF: 13.3 TOP: Hedging with Futures
MSC: Applied

10. Hedging with forwards and futures contracts is different due to the nature of the two contracts. Which
of the following statements is incorrect in terms of a comparison of the two derivatives?
a. Forward contracts are better at reducing legal risk.
b. Futures contracts are better at reducing transaction costs.
c. Futures contracts are better at reducing credit risk.
d. Futures contracts are more standardized.
e. Futures contracts are better at reducing liquidity risk.

ANS: A DIF: Easy REF: 13.3 TOP: Hedging with Futures
MSC: Conceptual
141

11. Suppose that the variance of quarterly changes in the spot prices of a commodity is 0.49, the
variance of quarterly changes in a futures price on the commodity is 0.81, and the coefficient of
correlation between the two changes is 0.6. The optimal hedge ratio for the contract is:
a. 0.10
b. 0.4667
c. 0.5444
d. 0.9

ANS: B DIF: Easy REF: 13.4 TOP: Risk-Minimization Hedging
MSC: Applied

12. Suppose that the variance of quarterly changes in the spot prices of a commodity is 0.49, the
standard deviation of quarterly changes in a futures price on the commodity is 0.64, and the coefficient of
correlation between the two changes is 0.8. The optimal hedge ratio for the contract is:
a. 0.771
b. 0.363
c. 0.700
d. 0.875

ANS: D DIF: Moderate REF: 13.4 TOP: Risk-Minimization Hedging
MSC: Applied

13. The variance of monthly changes in the spot price of live cattle is (in cents per pound) is 1.7. The
variance of monthly changes in the futures price of live cattle for the April contract is 1.5. The correlation
between these two price changes is 0.75. Today is March 11. The beef producer is committed to
purchasing 400,000 pounds of live cattle on April 15. The producer wants to use the April cattle futures
contract to hedge its risk. How many contracts should the producer buy, if the contract size is 40,000
pounds?
a. 5
b. 7
c. 8
d. 11

ANS: C DIF: Difficult REF: 13.4 TOP: Risk-Minimization Hedging
MSC: Applied

14. Kellogg will buy 2 million bushels of oats in two months. Kellogg finds that the ratio of the standard
deviation of the change in spot and futures prices over a two-month period for oats is 0.86 and the
coefficient of correlation between the two-month change in the price of oats and the two-month change in
its futures price is 0.75. How many contracts do they need to hedge their position, if the size of each oats
contract is 5,000 bushels, and oat trades in the CME Group?
a. 230
b. 258
c. 260
142
d. 279

ANS: B DIF: Moderate REF: 13.4 TOP: Risk-Minimization Hedging
MSC: Applied
1. The primary market for a stock is:

a. an initial public offering
b. an auction
c. a private placement
d. a subscription offering

TOP: Primary and Secondary Markets, Exchanges, and Over-the-Counter Markets
MSC: Factual

2. Which of the following is NOT true about stockholders?
a. A stockholder has fractional ownership over a company.
b. A stockholder usually gets dividend payments from a company.
c. A stockholder can lose more than her initial investment because the company is a “legal person” and mus
meet its debts and legal obligations.
d. A stockholder can play a role in changing the top management of the company.
e. A stockholder cannot be sued for misdeeds of a company.

ANS: C DIF: Moderate REF: 3.2 | 3.3
TOP: Primary and Secondary Markets, Exchanges, and Over-the-Counter Markets | Brokers, Dealers, and
Traders in Securities Markets MSC: Factual

3. US stock exchanges are:
a. regulated by the CFTC
b. regulated by the Congress
c. regulated by the Federal Reserve Bank
d. regulated by the EPA
e. regulated by the SEC

MSC: Factual

4. Which of the following statements about self-regulation of exchange-traded securities markets is
INCORRECT?
a. It makes the markets more honest.
b. It helps demonstrate to the federal agencies that the industry is doing a good job policing itself and thus m
regulatory oversight may not be necessary.
143
c. It deals with problems before they get wide publicity.
d. It builds the reputation of the marketplace and thus attracts high-quality customers and greater trade volu
e. Its net costs are far more than the benefits it provides.

TOP: Brokers, Dealers, and Traders in Securities Markets MSC: Factual

5. Which of the following is NOT true about a dealer?
a. A dealer has inventory risk.
b. A dealer matches a buyer and a seller and earns commissions for this service.
c. A dealer posts bid and ask prices.
d. A dealer must have adequate capital to maintain her portfolio of securities.
e. A dealer trades on her own account.


6. Which of the following is NOT true about a spread in a financial market?
a. A spread may refer to the gap between bid and ask prices of a stock or other security.
b. A spread may refer to the simultaneous purchase and sale of separate futures or options contracts for the
same commodity for delivery in different months.
c. A spread may refer to the difference between the price at which an underwriter buys an issue from a firm
the price at which the underwriter sells it to the public.
d. A spread may refer to the difference between the price that someone purchasing an item in an auction pa
and the price that the seller receives.
e. A spread may refer to the price an issuer pays above a benchmark fixed-income yield to borrow money.


7. The foreign exchange market is one of the world’s largest:
a. exchanges
b. primary markets
c. auction markets
d. dark pools
e. over-the-counter markets

MSC: Factual

8. The following individuals do not trade in the derivative securities markets:
a. day traders
b. market makers
c. position traders
144
d. scalpers
e. specialists

ANS: E DIF: Easy REF: 3.3 | 3.6
TOP: Brokers, Dealers, and Traders in Securities Markets | Buying and Selling Stocks
MSC: Factual

9. You are a dealer and post a price of $100.00 to $100.50 for a stock. There are more sell orders than
buy orders and you find your inventory is growing. What is the correct way to adjust your quotes?
a. Lower the bid price and then lower the ask price.
b. Lower the ask price and then lower the bid price.
c. Raise the ask price and then raise the bid price.
d. Raise the bid price and then raise the ask price.
e. Do nothing—orders arrive randomly and they will self-adjust.

ANS: A DIF: Moderate REF: 3.3
TOP: Brokers, Dealers, and Traders in Securities Markets MSC: Applied

10. Traders with superior information are more likely to trade in the:
a. stock market
b. bond market
c. money market
d. options market
e. swaps market

TOP: Brokers, Dealers, and Traders in Securities Markets MSC: Conceptual

11. Which statement below is INCORRECT?
a. Arbitrageurs seek price discrepancies among securities and attempt to extract riskless arbitrage profits.
b. Hedgers try to reduce risk by trading securities and are often cited as the chief reason for the existence o
derivative markets.
c. Position traders (also called trend followers) maintain speculative trading positions for longer periods of ti
d. Scalpers open their positions in the morning, try to profit from price movements over the day, and close th
positions at the end of the trading day.
e. Speculators often take calculated risks in their pursuit of profits.


12. Which statement below is INCORRECT about block trades?
a. They involve trades of 5,000 shares or more.
b. They involve trades of 10,000 shares or more.
c. They are often negotiated away from the trading floor in the “upstairs market.”
d. They may or may not involve the services of a broker.
145
e. They are rarely handled by the specialists.

ANS: A DIF: Easy REF: 3.6 TOP: Buying and Selling Stocks
MSC: Factual

13. Which statement below is correct about the Financial Industry Regulatory Authority (FINRA)?
a. FINRA is the successor to NASDAQ.
b. FINRA was created as a regulator of the stock market during the 1930s.
c. FINRA is the new name for NASD.
d. NASD and the member regulation, enforcement, and arbitration functions of the New York Stock Exchang
were consolidated to form FINRA.
e. FINRA operates the NASDAQ Stock Market LLC.

ANS: D DIF: Easy REF: 3.6 TOP: Buying and Selling Stocks
MSC: Factual

14. Which of the following is NOT true about an electronic communications network (ECN)?
a. It is an alternate trading system that must be registered with the SEC as a broker-dealer.
b. Its participants include institutional investors, broker-dealers, and market makers.
c. It publicly displays the limit order book to subscribers.
d. It is primarily a trading venue for stocks and currencies.
e. It is a secretive trading network that does not send an order directly to an exchange or display it in a limit
book.

ANS: E DIF: Easy REF: 3.6 TOP: Buying and Selling Stocks
MSC: Factual

15. A stock’s price cum-dividend is $50. If the market is free of riskless profit opportunities, then the ex-
dividend price of the stock after the payment of a $1 dividend would be:
a. $48
b. $49
c. $50
d. $51

TOP: Dollar Dividends and Dividend Yields MSC: Applied

16. Consider an asset that has a continuously compounded dividend yield of d = 0.03 per year, which is
reinvested back into the asset. Then, a unit investment in the asset today grows after ten months to:
a. 1.0202 units
b. 1.0228 units
c. 1.0253 units
d. 1.0279 units
146

TOP: Dollar Dividends and Dividend Yields MSC: Applied

17. Boni holds some YBM stocks in what’s called the “street name,” which enables her broker to short
her stocks. Her broker Brokerman helps Chini borrow those shares and short-sell them to Honey Bunny
at $100 per share. When YBM declares a $1 dividend, then:
a. YBM pays $1 to Boni
b. YBM pays $1 to Chini, who passes it on to Boni
c. Brokerman pays $1 to Boni from his own money
d. Chini pays $1 to Boni
e. Honey Bunny pays $1 to Boni

ANS: D DIF: Easy REF: 3.8 TOP: Short-Selling Stocks
MSC: Applied

18. Suppose that a stock trader has bought $20,000 worth of securities. He kept $10,000 in an initial
margin in his brokerage account and borrowed the rest from his broker. The maintenance margin is 25
percent. The value of the account has fallen to $3,500. The account holder has to come up with a
variation margin of:
a. $1,000
b. $1,500
c. $3,500
d. $6,500

ANS: B DIF: Moderate REF: 3.9
TOP: Margin: Security Deposits That Facilitate Trading MSC: Applied

19. Consider the following data: YBM’s stock price is $110. The initial margin is 50 percent and the
maintenance margin is 25 percent. If you buy 150 shares, borrowing 50 percent from the broker, at what
stock price will you start to receive a margin call? (Hint: use the formula Margin = (Market value of assets
– Loan) / Market value of assets.)
a. $25
b. $55.25
c. $66.67
d. $73.33

ANS: D DIF: Difficult REF: 3.9
TOP: Margin: Security Deposits That Facilitate Trading MSC: Applied
CHAPTER 6: Arbitrage and Trading

MULTIPLE CHOICE

1. Arbitrage is:
a. a zero initial wealth trading strategy that has a likelihood of making profits without risk of a loss
b. a way of resolving disputes
147
c. a risky way of making money for arbitrators
d. a zero-investment trading strategy in which the likelihood of portfolio gain overwhelms the likelihood of lo

ANS: A DIF: Easy REF: 6.1 TOP: Introduction
MSC: Factual

2. Which of the following class of arbitrage opportunities is irrelevant for our pricing models?
a. arbitrage across time
b. arbitrage across space
c. the sum of the parts is greater than the whole
d. the sum of the parts is less than the whole
e. government granted tax credits

ANS: E DIF: Easy REF: 6.2 TOP: The Concept of Arbitrage
MSC: Conceptual

3. Suppose a two-year Treasury note is trading at its par value of $1,000. You examine the cash flows
and discover that if you sell them individually in the market, you get $46.23 for the six-month coupon,
$44.67 for the one-year coupon, $42.21 for the eighteen-month coupon, $40.22 for the two-year coupon,
and $831.56 for the principal. The amount of arbitrage profit you can make by trading each security is:
a. $2.58
b. $4.89
c. $10.34
d. $41.78

ANS: B DIF: Easy REF: 6.2 TOP: The Concept of Arbitrage
MSC: Applied

4. The law of one price states that:
a. the same financial security, no matter how it is created, should trade at the same price
b. two financial securities that have the same price today and same risk must have the same price in the fut
c. two securities that have the same price today must have the same prices at all future dates
d. two securities that have the same standard deviation and expected return must have the same price

ANS: A DIF: Moderate REF: 6.2 TOP: The Concept of Arbitrage
MSC: Conceptual

5. Which statement below is FALSE?
a. Weak-form efficiency asserts that stock prices reflect all relevant information that can be gathered by
examining current and past prices.
b. If the market is weak-form efficient, then there are no arbitrage opportunities.
c. Semistrong-form efficiency asserts that stock prices reflect not only historical price information but also a
148
publicly available information that is relevant to those particular stocks.
d. Strong-form efficiency asserts that stock prices reflect all relevant information, both private and public, tha
be known to any market participant.

ANS: E DIF: Easy REF: 6.4 TOP: Efficient Markets
MSC: Factual

6. Which statement below is FALSE?
a. Technical analysis is useless in weak-form efficient markets.
b. Arbitrage opportunities may be present in semistrong-form efficient markets.
c. Fundamental analysis is worthless in semistrong-form efficient markets.
d. Insider trading restrictions are unnecessary in strong-form efficient markets.
e. Strong-form efficient markets are also weak-form efficient.

ANS: B DIF: Moderate REF: 6.4 TOP: Efficient Markets
MSC: Conceptual

Stock Today’s Price Tomorrow’s Price Shares Outstanding Today’s Tomorrow’s M
(Million) Market Value Value (Million
(Million)
YBM $98 $101 50 $4,900 $5,050
BUG $48 $49 20 $960 $980

7. A price-weighted index’s value would be:
a. 71 today and 75 tomorrow
b. 68 today and 70 tomorrow
c. 69 today and 71 tomorrow
d. 73 today and 75 tomorrow

TOP: In Pursuit of Arbitrage Opportunities MSC: Applied

8. A value-weighted index’s value would be (assuming today’s value is normalized to 100):
a. 100 today and 101.08 tomorrow
b. 100 today and 102.40 tomorrow
c. 100 today and 102.90 tomorrow
d. 100 today and 103.80 tomorrow

TOP: In Pursuit of Arbitrage Opportunities MSC: Applied

149
9. An index arbitrage involves buying the cheaper portfolio and selling the more expensive portfolio
where:
a. the portfolios try to replicate the performance of two different but related stock indexes
b. one portfolio consists of an index future while the other portfolio tries to replicate the performance of the
underlying index
c. one portfolio consists of an index option while the other portfolio tries to replicate the performance of the
underlying index
d. one portfolio consists of an index future while the other portfolio consists of an index option, where both
derivatives are written on the same underlying index

TOP: In Pursuit of Arbitrage Opportunities MSC: Factual

10. Which of the following is NOT a characteristic of algorithmic trading (or algos)?
a. Algos are a kind of program trading that try to exploit fleeting mispricings or arbitrage opportunities.
b. An objective of algos is to reduce latency, or the time duration between order placement and execution.
c. Algos require trades to have real-time settlement.
d. Servers for conducting algos are placed near the trading venue for reducing latency.


11. Which of the following is NOT a characteristic of a hedge fund?
a. They allow only wealthy investors to invest.
b. They hedge all of their investment risks.
c. Hedge fund managers tend to specialize in one investment strategy, but enjoy broad investment flexibility
d. Hedge funds are structured so as to avoid direct regulation and taxation in most countries.
e. Hedge funds have a penchant for secrecy and disclose little information to the public.


12. Which of the following is NOT an example of floor trading abuse?
a. bucketing
b. cross trading
c. ginzy trading
d. prearranged trading
e. rolling the hedge forward

TOP: Illegal Arbitrage Opportunities MSC: Factual

13. Front running in futures market involves:
150
a. a floor broker who executes customer orders acting as a dealer in some other transactions on the same d
b. trading based on an impending transaction by another person, for example, a floor trader buying on his o
account in front of his customer’s buy order
c. taking a customer’s order and placing it ahead of accumulated limit orders
d. placing orders during the first few minutes of a trading day

TOP: Illegal Arbitrage Opportunities MSC: Factual

14. Which of the following statements is FALSE? In the United States, to prove market manipulation in a
court of law:
a. the manipulator must be shown to have had the ability to set an artificial futures price
b. the manipulator must have intended to set an artificial price
c. the manipulator must have succeeded in setting an artificial price
d. it is difficult to demonstrate that price movements are due to the manipulator’s trades and not due to chan
market conditions
e. many manipulators are wrongly prosecuted because manipulation trades, like speculation trades, enhanc
market efficiency by enabling prices to reflect information quickly

ANS: E DIF: Moderate REF: 6.6
TOP: Illegal Arbitrage Opportunities MSC: Conceptual
CHAPTER 12: The Extended Cost-of-Carry Model

MULTIPLE CHOICE

1. In a simple cost-of-carry model with dollar dividends, we:
a. lower the stock price by the present value of all future dividends
b. lower the stock price by the present value of all future dividends paid over the forward’s life
c. lower the stock price by more than the amount of the dividends due to taxes and transactions costs
d. lower the stock price by less than the amount of the dividends due to the signaling effect of dividends
e. adjust the quantity of shares held for dividends and not the stock price

TOP: Forwards on Dividend-Paying Stocks MSC: Conceptual

2. BUG’s stock price S is $50 today. It pays a dividend of $0.25 after two months. If the continuously
compounded interest rate is 4 percent per year, then the six-month forward price on BUG stock is:
a. $49.75
b. $50
c. $50.45
d. $50.76

TOP: Forwards on Dividend-Paying Stocks MSC: Applied
151

3. BUG’s stock price S is $50 today. It pays a dividend of $0.25 after two months and $0.30 after five
months. If the continuously compounded interest rate is 4 percent per year, then the forward price of a
six-month forward contract on BUG is:
a. $49.75
b. $50
c. $50.46
d. $50.76


months. The continuously compounded interest rate is 4 percent per year. If the six-month forward price
is $51, the arbitrage profit that you can make today by trading one forward contract and other securities
is:
a. 0
b. $0.18
c. $0.41
d. $0.53


months. The continuously compounded interest rate is 4 percent per year. Transactions costs are $0.10
per stock traded, a $0.25 one-time fee for trading forward contracts, and no charges for trading bonds. If
the six-month forward price is $51, the arbitrage profit that you can make today by trading one forward
contract and other securities is:
a. 0
b. $0.18
c. $0.41
d. $0.53


6. The following is NOT an implication of the cost-of-carry relation for valuing a stock index futures
contract:
a. the futures price depends directly upon the level of the stock market index
b. if the stocks in the index increase the level of dividend payments over the life of the futures contract, the f
price will fall, with everything else constant
c. if the level of interest rates increases, the futures price will increase, with everything else constant
d. if the level of interest rates increases, the futures price will decrease, with everything else constant
152

TOP: Forwards on Dividend-Paying Stocks MSC: Conceptual

7. Assume that interest rates are constant. Given a risk-free rate of 6 percent, a dividend yield of 2
percent, and index level of 1,100, then the stock market index futures price with delivery in 3 months is:
a. 1,000.01
b. 1,111.06
c. 1,040.00
d. 10,000.10


8. Some index funds modify the index matching strategy to boost performance. Such strategies do NOT
include the following:
a. investing dividend income to buy stocks in the same proportion as in the index as soon as they arrive
b. buying futures instead of stocks when futures are cheaper
c. picking up extra income by lending securities
d. temporarily holding a bit more of a thinly traded stock than is called for in a benchmark
e. buying stocks being added to an index in advance of the effective date of those changes

TOP: Forwards on Dividend-Paying Stocks MSC: Factual

9. Which of the following statements is INCORRECT about exchange-traded funds (ETFs)?
a. ETFs are securities giving the holder fractional ownership rights over a basket of securities.
b. ETFs trade on exchanges continuously during trading hours.
c. ETF trades require brokerage commissions.
d. ETF shares cannot be shorted.
e. Arbitrage helps to ensure that an ETF’s price will not move too far from its net asset value.


10. Which of the following statements is INCORRECT?
a. A stock market index is a hypothetical portfolio formed according to some criteria or rules.
b. Most indexes, unlike total return indexes, make no adjustment for regular cash dividends.
c. Total return indexes assume that all disbursements from the company including regular dividends get
reinvested in the hypothetical index portfolio.
d. The cost-of-carry model that has a total return index as the underlying requires dividend adjustments.
e. The cost-of-carry model that uses indexes like the Dow Jones Industrial Average and the Standard and P
500 index requires dividend adjustments.
153


11. Which of the following statements about a stock index is INCORRECT?
a. A stock index is a hypothetical portfolio formed according to some criteria or rules.
b. A stock index can be sold short.
c. A stock index gives a quick sense of the performances of the market or a sector of the economy.
d. A stock index provides a benchmark against which performance of fund managers are measured.
e. A stock index can be used for creation of derivative products.


12. Consider the “SINDY index” obtained by averaging stock prices and a synthetic index “SINDY spot”
that replicates its performance. SINDY’s current level I is 11,000 and the synthetic index’s price S is
$11,000. Stocks constituting SINDY spot paid $200 in dividends last year and are expected to pay the
same this year. Let the continuously compounded interest rate r be 5 percent per year. Then the six-
month forward price on a newly written forward contract on SINDY is:
a. $10,981
b. $11,176
c. $11,201
d. $11,276


13. Consider the “SINDY index” obtained by averaging stock prices and a synthetic index “SINDY spot”
that replicates its performance. SINDY’s current level I is 11,000 and the synthetic index’s price S is
$11,000. Stocks constituting SINDY spot paid $200 of dividends last year and are expected to pay the
same this year. Let the continuously compounded interest rate r be 5 percent per year. If the six-month
forward price on a newly written forward contract on SINDY is being quoted in the market for 11,200,
then the arbitrage profit that you can make today by trading one contract as well as other securities is:
a. 0
b. $5
c. $17
d. $23


14. Today’s spot exchange rate SA is $1.30 per euro in American terms. The continuously compounded
annual risk-free interest rates are r = 4 percent in the United States (domestic) and rE = 3 percent in the
Eurozone. Then a trader using the cost-of-carry model will quote the six-month forward rate in American
terms as:
a. $1.2107
154
b. $1.3005
c. $1.3065
d. $1.3508

ANS: C DIF: Easy REF: 12.3

15. Turkish interest rates are 4 percent per annum, while US interest rates are at 5 percent per annum.
The spot exchange rate is 1.75 Turkish lira per US dollar, while the six-month forward price is 1.70 lira
per US dollar. The arbitrage profit that you can generate today by trading one six-month forward contract
and other securities is:
a. $0.057
b. $0.137
c. $0.374
d. $0.574


16. The spot exchange rate is $0.56 per Brazilian real in American terms. Assume interest rates are
continuously compounded. A US dollar invested in Treasury bonds grows to $1.0101 after ninety days. A
real invested in risk-free Brazilian government Treasury securities grows to 1.0113 reals at the end of the
same time period. A broker offers to trade a ninety-day forward contract to buy or sell 1 million reals at
the exchange rate of $0.55 per real. The arbitrage profit that you can make today by trading one forward
and other securities is approximately equal to:
a. $7,550
b. $9,242
c. $10,546
d. $17,630

ANS: B DIF: Difficult REF: 12.3

17. Alloyum costs $0.10 per month to store (which is paid up front) but gives a convenience yield of
$0.12 per month (which is received on the maturity date). If Alloyum’s spot price S is $200 per ounce and
the continuously compounded interest rate r is 5 percent per year, then the six-month forward price is:
a. $204.96
b. $210.03
c. $205.05
d. $224.93

TOP: Extended Cost-of-Carry Models MSC: Applied
155

18. COMIND index is computed by averaging commodity prices. Compute the six-month forward price for
this index if the spot price is 1,000 and the continuously compounded annual rates for various costs and
benefits are 5 percent for the interest rate, 2 percent for the dividend yield, 3 percent for the storage cost,
and 1 percent for the convenience yield.
a. $1,021.05
b. $1,025.32
c. $1,030.45
d. $1,040.81

TOP: Extended Cost-of-Carry Models MSC: Applied

19. When the forward price is less than the expected future spot price, we say that the:
a. market is in backwardation
b. market is in contango
c. market is in normal backwardation
d. net hedging hypothesis is in effect

TOP: Backwardation, Contango, Normal Backwardation, and Normal Contango
MSC: Factual

20. A trader can borrow money at 6 percent and lend money at 5 percent, where the interest rates are
continuously compounded annual rates. A brokerage commission of 0.5 percent of the stock price is
charged today but the broker waives transactions costs on the maturity date. If BUG’s stock price S is
$50 today, then the seven-month forward price on BUG’s stock should lie between:
a. $51.22 and $52.04
b. $51.47 and $51.78
c. $51.22 and $52.54
d. $51.22 and $51.47

ANS: A DIF: Moderate REF: 12.6 TOP: Market Imperfections
MSC: Applied
*Ex. 17-137—Fair value hedge.
On January 2, 2019, Tylor Co. issued a 4-year, £500,000 note at 6% fixed interest, interest payable semiannually. Tylor now
wants to change the note to a variable rate note. As a result, on January 2, 2019, Tylor Co. enters into an interest rate swap
where it agrees to receive 6% fixed and pay LIBOR of 5.6% for the first 6 months on £500,000. At each 6-month period, the
variable interest rate will be reset. The variable rate is reset to 6.6% on June 30, 2019.
Instructions
(a) Compute the net interest expense to be reported for this note and related swap transaction as of June 30,
2019.
(b) Compute the net interest expense to be reported for this note and related swap transaction as of
December 31, 2019.
156
*Solution 17-137
(a) and (b)
6/30/19 12/31/19
Fixed-rate debt £500,000 £500,000
Fixed rate (6% ÷ 2) X 3% X 3%
Semiannual debt payment £ 15,000 £ 15,000
Swap fixed receipt (15,000) (15,000)
Net income effect £ 0 £ 0
Swap variable rate
5.6% × ½ × £500,000 £ 14,000
6.6% × ½ × £500,000 0 £ 16,500
Net interest expense £ 14,000 £ 16,500
*Ex. 17-138—Cash flow hedge.

On January 2, 2018, Sloan Company issued a 5-year, €8,000,000 note at LIBOR with interest paid annually. The variable rate is
reset at the end of each year. The LIBOR rate for the first year is 6.8%
Sloan Company decides it prefers fixed-rate financing and wants to lock in a rate of 6%. As a result, Sloan enters into an interest
rate swap to pay 7% fixed and receive LIBOR based on €8 million. The variable rate is reset to 7.4% on January 2, 2019.
Instructions
(a) Compute the net interest expense to be reported for this note and related swap transactions as of
December 31, 2018.
(b) Compute the net interest expense to be reported for this note and related swap transactions as of
December 31, 2019.
157
*Solution 17-138
(a) and (b)
12/31/18 12/31/19
Variable-rate debt €8,000,000 €8,000,000
Variable rate X 6.8% X 7.4%
Debt payment € 544,000 € 592,000
Debt payment € 544,000 € 592,000

Swap receive variable (544,000) (592,000)
Net income effect € 0 € 0
Swap payable—fixed 560,000 560,000
Net interest expense € 560,000 € 560,000
*Pr. 17-142—Derivative financial instrument.

Hummel Co. purchased a put option on Olney ordinary shares on July 7, 2018, for €100. The put option is for
200 shares, and the strike price is €30. The option expires on January 31, 2019. The following data are
available with respect to the put option:
Date Market Price of Olney Shares Time Value of Put Option

September 30, 2018 €32 per share €53
December 31, 2018 €31 per share 21
January 31, 2019 €33 per share 0
Instructions
Prepare the journal entries for Hummel Co. for the following dates:
(a) July 7, 2018—Investment in put option on Olney shares.
(b) September 30, 2018— Hummel prepares financial statements.
(c) December 31, 2018— Hummel prepares financial statements.
(d) January 31, 2019—Put option expires.
*Solution 17-142
July 7, 2018
(a) Put Option.................................................................................... 100
Cash................................................................................. 100
September 30, 2018

(b) Unrealized Holding Gain or Loss—Income................................... 47
158
Put Option (€100 – €53).................................................... 47

December 31, 2018
(c) Unrealized Holding Gain or Loss—Income................................... 32
Put Option (€53 – €21)...................................................... 32
January 31, 2019

(d) Loss on Settlement of Put Option................................................. 21
Put Option (€21 – €0)........................................................ 21
*Pr. 17-143—Free-standing derivative.

Welch Co. purchased a put option on Reese ordinary shares on January 7, 2019, for €215. The put option is
for 300 shares, and the strike price is €51. The option expires on July 31, 2019. The following data are
Date Market Price of Reese Shares Time Value of Put Option

March 31, 2019 €48 per share €120
June 30, 2019 €50 per share 54
July 6, 2019 €46 per share 16
Instructions
Prepare the journal entries for Welch Co. for the following dates:
(a) January 7, 2019—Investment in put option on Reese shares.
(c) March 31, 2019— Welch prepares financial statements.
(d) June 30, 2019— Welch prepares financial statements.
(e) July 6, 2019— Welch settles the call option on the Reese shares.
*Solution 17-143
January 7, 2019
(a) Put Option.................................................................................... 215
Cash................................................................................. 215
March 31, 2019

(b) Put Option.................................................................................... 900
159
Unrealized Holding Gain or Loss—Income (€3 × 300)...... 900
Unrealized Holding Gain or Loss—Income................................... 95

Put Option (€215 – €120).................................................. 95
June 30, 2019
Put Option (€2 × 300)....................................................... 600

Put Option (€120 – €54).................................................... 66
160
July 6, 2019
(d) Unrealized Holding Gain or Loss—Income................................... 38
Put Option (€54 – €16)...................................................... 38
Cash (300 × €5)............................................................................ 1,500

Gain on Settlement of Put Option..................................... 1,184
Put Option*....................................................................... 316
*Value of Put Option settlement:
Put Option
215
900 95
600
66
38
316
Explanation of numbering system: The first one or two digits before the period refer to the textbook chapter to
which the question pertains. The digits after the period refer to the number of the Test Bank question
pertaining to the designated chapter. Thus, “3.1” refers to the first question pertaining to Chapter 3.
The quiz and final exam questions will be similar are style the questions found in this Test Bank.
Note that the default assumption in this course is that interest rates and dividend yields are assumed to be
quoted on a per annum and continuously compounded basis.
Chapter 1: Introduction
1.1. A trader enters into a one-year short forward contract to sell an asset for $60 when the spot price is $58.
The spot price in one year proves to be $63. What is the trader’s profit?
Loss of $3
1.2. A trader buys 100 European call options with a strike price of $20 and a time to maturity of one year.
Each option involves one unit of the underlying asset. The cost of each option or option premium is $2. The
price of the underlying asset proves to be $25 in one year. What is the trader’s profit?
Profit of $300
1.3. A trader sells 100 European put options with a strike price of $50 and a time to maturity of six months.
Each option involves one unit of the underlying asset. The price received for each option is $4. The price of
the underlying asset is $41 in six months. What is the trader’s profit?
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Loss of $500
1.4. The price of a stock is $36 and the price of a 3-month call option on the stock with a strike price of $36 is
$3.60. Suppose a trader has $3,600 to invest and is trying to choose between buying 1,000 options and 100
shares of stock. How high does the stock price have to rise for an investment in options to be as profitable
as an investment in the stock?
$40 Note that we are trying to solve the following equation for P, the stock price: (P-36)100 = (P-36)1000
-3,600
1.5. A one year call option on a stock with a strike price of $30 costs $3. A one year put option on the stock
with a strike price of $30 costs $4. A trader buys two call options and one put option.
A.) What is the breakeven stock price, above which the trader makes a profit?
B.) What is the breakeven stock price below which the trader makes a profit?
A.) $35 since 2=10/x’ where x’ is the amount by which the breakeven price exceeds $30, the strike price.
Note that x = 30 + x’.
B.) $20 since 1=10/y’ where y’ is the amount by which the breakeven price falls short of $30, the strike
price. Note that y = 30 – y’.
$30
y x
Chapter 2: Mechanics of Futures Markets
2.1. A company enters into a short futures contract that involves 50,000 pounds of cotton for 70 cents per
pound. The initial margin is $4,000 and the maintenance margin is $3,000. What is the futures price above
which there will be a margin call?
$0.72 since we are trying to solve the equation: ($.70-P) 50,000 = - $(4,000-3,000)
2.2. A company enters into a long futures contract involving 1,000 barrels of oil for $20 per barrel. The initial
margin is $6,000 and the maintenance margin is $4,000. What oil futures price will allow $2,000 to be
withdrawn from the margin account?
$22 since we are trying to solve the equation: 1000(P-20) = $2,000
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Note that an amount can be withdrawn from the margin account when P, the settlement price on the day of
the transaction of the oil futures contract, exceeds $20.
2.3. On the floor of a futures exchange one futures contract is traded where both the long and short parties
are closing out existing positions. What is the resultant change in the open interest?
Open interest drops by one.
2.4. You sell 3 December gold futures when the futures price is $410 per ounce. Each contract is on 100
ounces of gold and the initial margin per contract is $2,000. The maintenance margin per contract is $1,500.
During the next 7 days the futures price rises steadily to $412 per ounce. What is the balance of your margin
account at the end of the 7 days?
$5,400 since the total initial margin of 3X$2,000 is reduced by 3X$(412-410)X100=$600
2.5. A hedger takes a long position in an oil futures contract on November 1, 2009 to hedge an exposure on
March 1, 2010. Each contract is on 1,000 barrels of oil. The initial futures price is $20. On December 31,
2009 the futures price is $21 and on March 1, 2010 it is $24. The contract is closed out on March 1, 2010.
What gain is recognized in the accounting year January 1 to December 31, 2010?
$4,000 = 1000 X $(24-20)
2.6. Answer 2.5 this time assuming that the trader in question is a speculator rather than a hedger.
$3,000 = 1000 X ($24-21)
2.7. A speculator enters into two short cotton futures contracts, when the futures price is $1.20 per pound.
The contract entails the delivery of 50,000 pounds of cotton. The initial margin is $7,000 per contract and the
maintenance margin is $5,250 per contract. The settlement price on the day of the transaction is $1.50 per
pound. Assume that all days are trading days.
Notes:
1.) If there is a margin call on a certain day, the deadline for depositing the variation margin (which is the
additional margin that should be deposited into the margin account due to a margin call) is the trading day
after the day of the margin call. The assumption made in this course is that the variation margin is deposited
at the deadline date, i.e. the trading day after the day of the margin call.
2.) Margin calls are established at the settlement price, i.e. margin calls are established at the end of the
trading day.
A.) How much must the speculator deposit into his margin account on the day of the transaction?
Initial margin = 2 x $7,000 = $14,000
B.) What is the amount of the margin call, if any, that is declared on the day of the transaction?
Automatic credit to MAB (margin account balance) due to adverse move in the futures price, i.e., transaction
price of 1.20 is less than the settlement price of 1.50, = 2 x 50,000 x (1.20 – 1.50) = -$30,000. A negative
credit is a debit, i.e., the MAB is reduced by $30,000.
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The initial margin that is deposited of $14,000 is reduced by $30,000, resulting in a MAB of -$16,000. As the
latter is below the maintenance margin of $5,250 x 2 or $10,500, an additional deposit of $30,000 is required
to bring the MAB back to the initial margin. The margin call thus equals $30,000.
C.) How much must the speculator deposit into his margin account, i.e. what is the variation margin, on
the day after the transaction?
The margin call or variation margin of $30,000, calculated in B.), must be deposited. Note that margin calls
or variation margins must be deposited on or before the trading day after the day of the margin call.
2.8. On a certain day a speculator enters into 10 long soybean futures contracts, when the futures
price is $10.20 per bushel. The contract involves 5,000 bushels of soybean. The initial margin is
$4,000 per contract and the maintenance margin is $3,000 per contract. The settlement price on that
day is $10.05 per bushel. How much must the speculator deposit into his margin account on day 1?
Note: Quiz and exam questions will broach what transpires on only one trading day.
Initial margin = $4,000 x 10 = $40,000

Maintenance margin = $3,000 x 10 = $30,000
Automatic credit = 10 x 5,000 (10.05 – 10.20) = -7,500
Margin account balance = 40,000 – 7,500 = 32,500 which exceeds maintenance margin of 30,000. Thus,
there is no variation margin required, i.e. there will be no margin call. Deposit for day 1 = $40,000
2.9. List and explain briefly the possible effects of a single futures transaction on open interest.
Open interest rises by 1 if both long and short positions are opening transactions.
Open interest does not change if one of the long or short positions is an opening transactions whereas the
other position is a closing transaction.
Open interest drops by 1 if both long and short positions are closing transactions.
Chapter 3: Hedging Strategies Using Futures
3.1. On March 1 the spot price of oil is $20 and the July futures price is $19. On June 1 the spot price of oil
is $24 and the July futures price is $23.50. A company entered into a futures contract on March 1 to hedge
the purchase of oil on June 1. It closed out the position on June 1. What is the effective price paid by the
company for the oil?
$19.50 = $24 + $(19 - 23.50). Hedging involves adding a hedge $(19 – 23.50) to an initial exposure $24.
Alternatively, $19.50 = $19 + $(24 - 23.50). Hedging involves taking an initial futures position $19 and a
basis $(24 – 23.50) that substitutes for the exposure.
3.2. On March 1 the spot price of gold is $300 and the December futures price is $315. On November 1 the
spot price of gold is $280 and the December futures price is $281. A gold producer entered into a December
164
futures contract on March 1 to hedge the sale of gold on November 1. It closed out its position on
November 1. What is the effective price received by the producer for the gold?
$314 = $280 + $(315 - 281) or alternatively, $314 = $315 + $(280 – 281).
See 3.1 for the interpretations of these two equivalent calculations.
3.3. The standard deviation of monthly changes in the price of a commodity A is $2. The standard deviation
of monthly changes in a futures price for a contract on commodity B, which is similar to commodity A, is $3.
Note: This is an example of cross-hedging. The correlation between the futures price and the commodity
price is 0.9.
A.) What hedge ratio should be used when hedging a one month exposure to the price of commodity A?
0.6 = .9 (2/3)
B.) What is the associated hedging effectiveness? Interpret what this means.
.81 = (.9)^2 The proportion of the variance of commodity A that can be eliminated by hedging with
commodity B futures is 81%.
Note: A perfect hedge is one whose measure of hedging effectiveness is 100% or 1. This occurs when R^2
= 1. Alternatively, this occurs when the correlation between the changes in futures and spot prices equal 1.
3.4. A company has a $36 million portfolio with a beta of 1.2. The S&P 500 Index futures price currently
equals 900. What trade in S&P Index Futures is necessary to achieve the following? Indicate the number of
contracts that should be traded and whether the position is long or short.
A.) Eliminate all systematic risk in the portfolio.
Short 192 since N = (0-1.2) 36M/(900 x 250)= -192
Note: For S&P 500 Index futures contracts, F in the stock index formula equals 250xfutures price. For Mini
S&P 500 Index futures contracts, F in the stock index formula equals 50xfutures price.
B.) Reduce the beta to 0.9.
Short 48 = (.9-1.2)36M/(900 x 250) = -48
C.) Increase beta to 1.8.
Long 96 = (1.8 – 1.2)36M/(900 x 250) = 96
3.5. The standard deviation of weekly changes in the spot price of pork bellies is 2.3 cents per pound. For
pork belly futures that expire 6 weeks from now, the same standard deviation measures 3.9 cents per pound.
The correlation between these two prices, i.e., spot and futures, is 0.65. Each pork belly futures contract
entails the delivery of 20,000 pounds. A pork farmer is committed to delivering 100,000 pounds of pork
bellies 4 weeks from now.
A.) What should the pork farmer do to hedge his exposure?
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σS QA
(.65) 2.3100,000 =1.9 ≈ 2 Applying the anticipatory hedging rule, to
N =ρ =
σF QF 3.9 20,000
wit, do in the futures market now what you expect to do in the spot market in the future, the farmer should
short 2 futures contracts.
Parenthetical Note: The standard deviation for a 4-week period equals 4 times the 1week standard deviation.
Observe that as the same constant term of 4 is present in both numerator and denominator of the ratio of
standard deviations found in the formula, that constant term cancels out. Thus, the standard deviations
employed in the formula may both be 1-week standard deviations rather than 4-week standard deviations.
B.) What percent of his exposure can the pork farmer eliminate by hedging?
R 2 =ρ2 = (.65)2 = 42% The farmer can eliminate 42% of his exposure by hedging, i.e., observing the advice
offered in part A.).
3.6. An investment manager is in charge of a $55 million common stock portfolio whose beta equals 1.75.
The S&P 500 Index futures price currently equals 1040.
A.) What should the manager do to hedge his portfolio using S&P 500 Index futures contracts?
)
(
longN = β β* −
P
= (0 −1.75)
55M
=−370 Thus, the manager must short 370 S&P
F .26M
500 Index futures contracts. Note that F = 250 x 1040 = .26M, where M denotes a million.
B.)What should the manager do to increase the beta of his portfolio to a value of 2.2 using Mini S&P 500
Index futures contracts?
)
(
longN = β β* −
P
= (2.2 −1.75)
55M
= 476 Thus, the manager must take a long
F .052M
position in 476 Mini S&P 500 Index futures contracts. Note that F = 50 x 1040 = .052 M.
3.7. An agricultural cooperative would like to hedge the sale of one million bushels of grade 2 yellow corn
that is scheduled to take place a month from now, employing CME corn futures contracts. The contract
involves the delivery of 5,000 bushels of grade 1 yellow corn. The standard deviation of monthly changes in
grade 2 yellow corn prices per bushel equals $2.30 while the standard deviation of monthly changes in grade
1 yellow corn futures prices per bushel equals $ 2.62. The correlation between these two prices equals 0.89.
Presently, the price of grade 2 yellow corn per bushel equals $36.75 while the price of grade 1 yellow per
bushel equals $38.95.
A.) (4%) What do you recommend that the agricultural cooperative do, ignoring the tailing the hedge
adjustment?
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σS (.89) 2.3
= .7813
h =ρ =
σF 2.62
QA 1M
N=h = (.7813) =156
QF .005M
The cooperative should short 156 contracts.
Note that, in the absence of the phrase “ignoring the tailing the hedge adjustment,” you should take account
of tailing the hedge. This is because you are hedging a future spot transaction with a futures contract.
Hedging a future transaction with a futures contract always requires that the hedge be tailed because of
marking to market, i.e., the hedging activity generates immediate cash flows whereas the exposure pertains
to a future event. Thus, tailing the hedge is a time value of money adjustment.
B.) (4%) What do you recommend that the agricultural cooperative do, taking account of the tailing the hedge
adjustment?
S 36.75
NTH = N = (156) =147
F 38.95
Short 147 contracts.
Note that the textbook formula for Nth = h Va/Vf and the above formula are equivalent. This is because the
quantity in the textbook formula numerator is Va = Qa x S and the quantity in the textbook formula
denominator is Vf = Qf x F.
3.8. An investment manager, who is in charge of a $100 million stock portfolio with a beta of 1.5, projects that
the stock market during the year that has just started will rise. He wishes to speculate on this belief. There
are two actions he could take, namely, reduce the portfolio beta to 1 or raise it to 2. The S&P 500 Index
futures price currently equals 1,200. What position should the investment manager take in Mini S&P 500
Index futures contracts?
( P
LongN = β β∗ − ) F = (2 −1.5)
100 M
.06M = 833
F = 50 1,200x = .06M
Take long position in 833 contracts.
Chapter 4: Interest Rates
4.1. An interest rate is 15% per annum with annual compounding. What is the equivalent rate with
continuous compounding?
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13.98% since 1.15 = e^R implies R = 13.98%
4.2. An interest rate of 12% assumes quarterly compounding. What is the equivalent rate with semiannual
compounding?
12.18% since (1 + 12%/4 ) = (1 + R/2)^2 implies R = 12.18%
4.3. A.) The 3-year zero rate is 7% and the 4-year zero rate is 7.5%, both continuously compounded. What
is the forward rate for the fourth year?
9% =((7.5%)4 – (7%)3) / (4-3)
4.3 B.) For the situation depicted in part A.), what contractual interest rate would be appropriate for a one-
year FRA that starts 3 years from now?
The continuously compounded forward rate of 9% must be restated as the equivalent forward rate with
annual compounding, i.e. e^9% = (1+R). Thus, the contractual forward rate for the FRA is R = 9.42%.
Note that the quoted contractual forward rate of an FRA assumes a compounding period equal to the length
of the FRA period. In this case, the FRA period is one year.
4.4. The 6-month zero rate is 8% with semiannual compounding. The price of a 1-year bond that provides a
coupon of 6% per annum semiannually is 97. What is the one year zero rate continuously compounded?
9.02% since 3/1.04 + 103e^R = 97 implies R = 9.02%
The foregoing is a short problem on the bootstrapping procedure for generating the zero curve.
4.5. The zero curve is flat at 5.91% with continuous compounding. What is the value of an FRA to an FRA
seller where the FRA interest rate is 8% per annum on a principal of $1,000 for a 6-month period that start 2
years from now?
Notes:
1.) FRA interest rates are quoted assuming a compounding period equal to the length of the FRA period.
Thus, the 8% should be interpreted as semi-annually compounded.
2.) Since the zero curve is flat, all forward interest rates equals the constant value of the interest rate.
Thus, the relevant forward rate is 5.91% continuously compounded or 6% with semi-annual compounding.
3.) This problem asks you to value the FRA post-inception. At inception, the value of an FRA equals 0.
4.) The seller of an FRA receives the contractual interest rate of the FRA. The seller is hedging a floating
rate deposit.
$8.63 = 1000(.08-.06).5 x e^-5.91%(2.5)
or $8.63 = 1000(.08-.06).5 / (1.03)^5
4.6.A.) The 1-year spot (or zero) rate equals 5% and the 15-month spot rate equals 5.6%. What is the
forward rate pertaining to the quarter that starts a year from now? All the interest rates cited here are
expressed with continuous compounding.
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5.6%(1.25) 5%(1)
RF == 8%
4.6.B.) A firm, confronting the situation in part A.), wishes to purchase an FRA (Forward Rate Agreement) for
the 1-quarter period that starts a year from now. What value of the contractual rate should the firm expect
from a bank? By convention, the interest rates associated with an FRA assume a compounding period equal
to the FRA’s time period.
e8%(.25) =⎛⎜1+ R4 ⎞⎟= 8.08%

⎝ 4⎠
4.7. A 6-month T-bill is currently trading at $94. A 7% coupon rate 1-year maturity bond currently trades at
$90. What are the 6-month and 1-year zero rates? All interest rates cited here are continuously
compounded. The bond is a traditional North American bond that pays coupons semi-annually.
94 =100e−R 0.5 (0.5)
R0.5 =12.375%
90 = 3.5e−12.375%(0.5) +103.5eR (1) 1
R1 =17.7%
4.8. A company has entered into an FRA (Forward Rate Agreement), which specifies that the company will
receive 7%, quoted with semi-annual compounding, on a principal of $100 million for the 6-month period
starting a year from now. The 1-year spot rate and the 18-month spot rate are 7% and 7.5%, respectively,
both rates expressed as continuously compounded rates. What is the value of the company’s FRA?
7.5%(1.5) 7%(1)
RF == 8.5%
8.5%(.5) (1 R 2)
e =+
2 R2 = 8.68%
VFRA =[100Mx(7% −8.68%) .5x ]e−7.5%(1.5) =−$750,622
4.9 A.) A 1-year maturity T-bill is trading at $94. A 1-year maturity semi-annual payment bond with a coupon
rate of 6% trades at $99.74. What are the 6-month and 1year zero rates? (For all parts of this question, all
interest rates are continuously compounded.)
100 = 94eR1(1) R1 = 6.19%
99.74 = 3e−R. (.5).5 +103e−.0619(1)
R0.5 = 5.41%
4.9 B) Without performing any additional calculations, determine the range of values within which the yield on
a 1-year maturity semi-annual payment bond should lie.
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R0.5 < yield < R1 , i.e. the yield is “in between” the short and the long zero rates. Thus,
5.41% < yield < 6.19%
4.9 C.) Without performing any additional calculations, what can you infer about the sixmonth that starts six
months from now?
The long zero rate is “in between” the short zero rate and the forward rate, i.e.
R0.5 < R1 < F . Thus, 6.19% < F.
4.10. Sometime ago, a company entered into an FRA (Forward Rate Agreement), which specifies that the
company will receive 7%, quoted with semi-annual compounding, on a principal of $100 million for the 6-
month period starting now. The observed 6-month rate equals 8%, quoted with semi-annual compounding.
Determine the amount of the settlement, i.e. how much must the company pay or receive now, the start of
the FRA period?
The company must pay the bank $480,770.
−$480,770 = 100M(7% −8%)0.5
8% ⎤
1+ ⎡
⎢⎣ 2 ⎥⎦
Chapter 5: Determination of Forward and Futures Prices
5.1. An investor shorts 100 shares when the share price is $50 and closes out the position 6 months later
when the share price is $43. The shares pay a dividend of $3 per share during the 6 months. What is the
investor’s profit?
$400 = (50 – 43 – 3) 100
5.2. The spot price of an investment asset that provides no income is $30. The risk-free rate for all maturities
is 10% with continuous compounding. What is the 3-year forward price?
$40.50 = 30 e^(.1x3)
5.3. The spot price of an investment asset is $30. The asset provides income of $2 at the end of the 1st year.
The asset also provides income of $2 at the end of the 2nd year. There is no additional income generated by
the asset during the 3-year life of a forward contract. The risk-free rate for all maturities is 10% with
continuous compounding. What is the 3-year forward price?
$35.84 = (30 – 2e^-.1 -2e^.-1x2)e^.1x3
5.4. The spot price of an investment asset that provides no income is $30. The risk-free rate for all maturities
is 10% with continuous compounding. What is the value of a long position in a 3-year forward contract where
the delivery price is $30?
$7.78 = 30 – 30 e^-.1x3
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5.5. A spot exchange rate is $0.7 and the 6-month domestic and foreign risk-free continuously compounded
interest rates are 5% and 7%, respectively. What is the 6month forward rate?
$0.693 = .7 e^(.05-.07)0.5
5.6. A short forward contract with a delivery price of $40 was negotiated sometime ago and will expire in 3
months. The current forward price for a 3-month forward contract is $42. The 3-month risk-free interest rate
is 8% with continuous compounding. What is the value of the short forward contract?
-$1.96 = (40-42) e^-.08x.25
5.7. The spot price of an asset is positively correlated with the market portfolio. The current 1-year futures
price of the asset is $10. What can you infer about the expected spot price of the same asset a year from
now, denoted E(S)?
E(S) > $10. In this situation, normal backwardation prevails.
5.8. The S&P 500 Index has a spot value of $1,095 with a continuously compounded dividend yield of 1%.
The continuously compounded interest rate is 5%. What should the 8-month futures price of the index be?
8
(5% 1%− )
12
F0 =1,095e = $1,124.60
5.9. The spot price of soybeans is $9.80 per bushel. The 9-month futures price of soybeans is $10.20 per
bushel. The interest rate and the cost of storage, both quoted as continuously compounded rates, equal 6%
and 2%, respectively. Soybeans are considered a consumption good. What is the inferred value of the
continuously compounded convenience yield on soybeans?
10.2 = 9.8e(6% 2%+ −y).75

y = 2.7%
5.10. The spot price of rape seed is $19 per bushel. The interest rate, the rape seed cost of storage, and the
rape seed convenience yield equal 5%, 1%, and 0.75%, respectively. All rates are expressed as
continuously compounded per annum rates. What should be the 6month futures price of rape seed?
F
0 =19e(5%+ −1% 0.75%).5
F0 = $19.51
Chapter 6: Interest Rate Futures
6.1. A trader enters into a long position in one Eurodollar futures contract. How much does the trader gain
when the futures quote increases by 6 basis points?
Gain of $150 = $25x6
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6.2. A company invests $1,000 in a 5-year zero-coupon bond and $4,000 in a 10-year zero-coupon bond.
What is the portfolio’s duration?
9 years = 5(1/5) + 10(4/5)
6.3. In February a company purchases 2 June Eurodollar futures contracts at 95.5. In June the final
settlement price of the contract is 97. What has the company accomplished?
In February, the company arranged to lock-in $2 million of investment at 4.5% = (100 – 95.5) % in June.
Note that, in the absence of the hedge, the firm would have had to invest at 3% = (100-97) %. After the fact,
the hedge was successful in the following specific sense: the firm arranged to invest at an interest rate that
turned out after the fact to be high.
6.4. In February a company decides to sell 3 June Eurodollar futures contracts at 95.5. In June the final
settlement price of the contract is 97. What has the company accomplished?
In February, the company arranged to lock-in $3 million of financing at 4.5% = (100 – 95.5) % in June. Note
that, in the absence of the hedge, the firm would have be able to finance at 3% = (100-97) %. After the fact,
the hedge was unsuccessful in the following specific sense: the firm locked-in financing at a rate that turned
out to be high after the fact.
6.5. A bond portfolio with a market value of $10 million has a duration of 9 years. The zero curve is flat at 6%
per annum compounded continuously. What happens to the market value of the portfolio if interest rates
were to rise to 6.5% per annum compounded continuously?
The market value of the portfolio will drop by $450,000, i.e. the change in the value of the portfolio equals -
$450,000 = - 9 (.5%) $10M
6.6. A bond portfolio with a market value of $10 million has a duration of 9 years. The zero curve is flat at 6%
per annum compounded semiannually. What happens to the market value of the portfolio if interest rates
were to rise to 6.5% per annum compounded semiannually?
The market value of the portfolio will drop by $436,893, i.e. the change in the value of the portfolio equals -
$436,893 = - {9/ (1 + .06/2)} (.5%) $10M. Note that the modified duration, {9/ (1 + .06/2)}, equals 8.74 years.
Chapter 7: Swaps
Problem 7.1 deals with the post-inception valuation of an interest rate swap. Parts A and
B view the value of a swap as the difference between two bonds, one being a fixed rate bond, and the other
being a floating rate bond. Parts C, D and E view the swap as a portfolio of forward contracts, i.e. a portfolio
of FRAs. Recall from chapter 4 that an FRA may be valued as if the projected forward rate will prevail.
7.1. The zero curve is flat at 5% per annum with continuous compounding. A swap with a notional principal
of $100 in which 6% is received and 6-month LIBOR is paid will last another 15 months. Payments are
exchanged every 6 months. The 6-month LIBOR rate at the last reset date, which occurred 3 months ago,
was 7%. The company in question receives fixed and pays floating interest rates. What is the value of the
swap to the company?
A.) What is the value of the fixed rate bond underlying the swap?
$102.61 = 3 e^-.05x.25 + 3 e^-.05x.75 + 103 e^-.05x1.25
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B.) What is the value of the floating rate bond underlying the swap?
$102.21 = (3.5 + 100) e^-.05x.25
3.5 equals .5 x 7% x 100, where 7% is 6-month LIBOR observed 3 months ago; 3.5 is the next interest rate
payment that will be paid 3 months from now. The floating rate bond will be worth its par value of 100
immediately after the next interest payment of 3.5.
Since the firm in question receives fixed and pays floating, the value of the swap =
$102.61 – $102.21 = $0.4
C.) What is the value of the payment that will be exchanged in 3 months?
-0.49 = (3-3.5) e^-.05x.25
Note that, with regard to part C, there is no uncertainty regarding the cash flows that will be exchanged 3
months from now. All uncertainty was resolved when 6-month LIBOR was observed 3 months ago at a value
of 7%.
D.) What is the value of the payment that will be exchanged in 9 months?
.45 = (3-2.5315) e^-.05x.75. The 5% forward rate continuously compounded is first restated as an interest
rate with semiannual compounding, i.e., 5.6302%. Thus, 2.5315 = 5.6302% x 100 x .5.
The swap cash flows 9 months from now are viewed as a 9-month FRA.
E.) What is the value of the payment that will be exchanged in 15 months?
.44 = (3-2.5315) e^-.05x1.25. The 5% forward rate continuously compounded is first restated as an interest
rate with semiannual compounding, i.e., 5.6302%. Thus, 2.5315 = 5.6302% x 100 x .5.
Viewing the interest rate swap as portfolio of FRAs with staggered maturities, the value of the swap to the
company that receives fixed and pays floating equals 0.4 = -.49 + .45 + .44
Note that the two swap interpretations yield consistent results.
7.2. Aussie Pty. Ltd. wishes to borrow USDs (U.S. dollars). Yank Corp. wishes to borrow AUDs (Australian
dollars). The following interest rates have been quoted.
Borrowing Firm Loan in AUDs Loan in USDs

Aussie Pty. Ltd. 11% 7%
Yank Corp. 10.6% 6.2%
A currency swap has been devised in which Aussie and Yank gain equally. The swap results in Aussie’s
and Yank’s net interest rate liabilities being exclusively in USDs and AUDs, respectively. The bank gains 10
basis points.
Note that Yank is a higher credit quality firm, enjoying an absolute advantage in both loan types. However,
Yank has a comparative advantage in USD debt, whereas Aussie has a comparative advantage in AUD
debt. Yank wants AUD debt whereas Aussie wants USD debt. Thus, the preconditions for a mutually
173
beneficial swap are satisfied, i.e. for both swap counterparties the desired type of debt differs from the type of
in which comparative advantage is enjoyed.
Interest rate differences 0.4% 0.8%
The total gain is the absolute value of the difference in interest rate differences, i.e. 0.4% or 40 bps. This
total gain is partitioned among the parties to the swap. The banks gains 10 bps. The remaining 30 bps is
shared equally between Yank and Aussie. Thus Yank and Aussie each gain 15 bps.
A.) What is the USD interest rate that Aussie must pay the bank as part of the swap? Aussie pays the
bank USD 6.85%.
Since Yank does not want any liability in USDs, the bank via the swap must compensate Yank for the 6.2%
in USD it must pay. Since Aussie does not want any liability in
AUDs, the bank via the swap must compensate Aussie for the 11% in AUD it must pay.
Aussie USD Bank AUD Yank

6.85% 10.45%
AUD
11% USD
6.2% USD
6.2%
AUD11%
B.) What is the AUD interest rate that Yank must pay the bank as part of the swap? Yank pays the bank
AUD 10.45%.
Yank’s gain = 10.6% - 10.45% = 0.15% or 15 bps

Aussie’s gain = 7% - 6.85 % = 0.15% or 15 bps
Bank’s gain = (6.85% - 6.2%) + (10.45% - 11%) = 0.10% or 10 bps
7.3. A $10 million notional principal interest rate swap has a remaining life of 5 months.
Under the terms of the swap, 3-month LIBOR is exchanged for 6% per annum
(compounded quarterly). The zero or spot rate for all maturities is 4% per annum compounded continuously.
The 3-month LIBOR rate was 3.5% per annum (compounded quarterly) a month ago.
A.) What is the value of the floating rate bond implicit in this interest rate swap?
Bfloat = (0 .0875 M + 10 M )e − 4 %( 2 /12 ) = $ 10 .0205 M
B.) What is the value of the fixed rate bond implicit in this interest rate swap?
Bfix = .15e−4%( 2 /12 ) + 10 .15 Me −4%( 5 /12 ) = $10 .1312 M

C.) What is the value of the swap to the swap counterparty that receives floating and pays fixed?
Value of swap = $10.0205M - $10.1312 M = -$0.1107 M
174
Problem 7.4 is an addendum to the boot-strapping procedure for generating the zero or spot curve that was
discussed in chapter 4. The new theoretical result that is exploited here is the following: The n-year semi-
annual payment swap rate is the n-year par yield on a bond.
7.4. The LIBOR zero rates for 6 months, 1 year, and 18 months equal 5.4%, 5.7%, and 6%
continuously compounded, respectively. The swap rate for a 2-year semi-annual payment swap
equals 6.6% with semi-annual compounding. What is the 2-year zero rate continuously
compounded?
3.3e−5.4%(.5) + 3.3e−5.7%(1) + 3.3e−6.6%(1.5) +103.3e−R2 =100
e−R2 = .8776
2-year zero rate or R = 6.53%
Problem 7.5 views a currency swap as the difference between two bonds, one denominated in USDs and the
other denominated in AUDs. In this case, the company pays in AUDs and receives in USDs. Thus, the
value of the swap in USDs is the value of the USD bond minus the value of the AUD bond, with the latter
converted into USDs at the current spot rate.
7.5. A currency swap has a remaining life of 9 months, the last exchange of cash flows having
occurred 3 months ago. The swap involves a company paying interest at 8% compounded semi-
annually on AUD 112 million and receiving interest at 5% compounded semi-annually on USD 100
million every six months. AUD denotes the Australian dollar and USD denotes the U.S. dollar. The
zero rates in Australia and the U.S. equal 7% and 4% continuously compounded, respectively, for all
maturities. The current exchange rate equals USD 0.95 per AUD. What is the value of the swap,
measured in USDs, to the company?
A.) Answer the question interpreting a swap as the difference between two bonds.
AUD :112Mx8% .x 5 = AUD4.48M

USD :100Mx5% .x 5 =USD2.5M
BAUD = 4.48Me−7%(.25) +116.48Me−7%(.75) = AUD114.925M
BUSD = 2.5Me−4%(.25) +102.5Me−4%(.75) =USD101.946M
Vswap = BUSD −.95xBAUD =101.946M −.95(114.925M) =−USD7.233M
B.) Answer the question interpreting a swap as a portfolio of forward contracts with staggered maturities.
3-month forward: F.25 = 0.95e(4%−7% .25) = .9429
f.25 =[USD2.5M − AUD4.48M(.9429)]e−4%(.25) =−USD1.71M
9-month forward:
F.75 = 0.95e(4%−7% .75) = .9289
175
f.75 =[USD102.5M − AUD116.48M(.9289)]e−4%(.75) =−USD5.53M
VSWAP = f.25 + f.75 =−USD1.71M −USD5.53M =−USD7.24M
Chapter 9: Mechanics of Options Markets

9.1. Consider an exchange traded put option to sell 100 shares for $20. Give the strike price and the
number of shares that can be sold after:
A.) A 5 for 1 stock split
$4 =$20/5; 500 = 100x5
B.) A 25% stock dividend
$16=$20/1.25; 125=100x1.25
C.) A $5 cash dividend
$20; 100
9.2. XY Company has 100 million shares outstanding. What happens to that number as a result of each of
the following events. Each event should be evaluated separately:
A.)Some exchange traded puts on XY stock are exercised.
B.) Some exchange-traded calls on XY stock are exercised.
C.) Some warrants on XY stock are exercised.
D.) Some bonds convertible to XY stock are converted.
For A. and B. the number of shares outstanding stays equal to 100 million shares. For C. and D. the number
of shares outstanding rises above 100 million shares.
9.3. A speculator writes (or sells) a call option with a strike price of $85 and a put option with a strike price of
$65 on one share of X Inc. common stock. Both options are European and expire a year from now. The call
premium is $7 whereas the put premium is $5. For what values of the yearend stock price will the speculator
generate a positive profit?
Option portfolio premium = $12
Positive profit generated for yearend stock price above $(65-12) or $53 and below $(85+12) or
$$97.
176
12
65 85
Chapter 10: Properties of Stock Options
10.1. What is the lower bound for the price of a 2-year European call option on a stock when the stock price
is $20, the strike price is $15, the risk-free rate is 5%, and there are no dividends?
$6.43 = 20 – 15(e^-.05x2)
is $20, the strike price is $15, and the risk-free rate is 5% and dividends of $1 per share are payable 6
months and 18 months from now?
$4.51 = 20 - 1 e^(-.05x.5) – 1 e^(-.05x1.5) - 15e^(-.05x2)
is $20, the strike price is $15, the risk-free rate is 5%, and the continuously compounded dividend yield is
1%?
$6.03 = 20e^(-.01x2) – 15e^(.05x2)
10.4. What is the lower bound for the price of a 2-year European put option on a stock when the stock price
is $20, the strike price is $15, the risk-free rate is 5%, and there are no dividends?
0. Note that 15(e^-.05x2)- 20 = -$6.43 but any option cannot have a negative value
10.5. What is the lower bound for the price of a 6-month European put option on a stock when the stock price
is $40, the strike price is $46, the risk-free interest rate is 6% and there are no dividends?
$4.64 = 46e^(-.06x.5) – 40
is $40, the strike price is $46, the risk-free interest rate is 6% and dividends per share of $2 are payable 3
months from now?
177
$6.61 = 46e^(-.06x.5) – (40 – 2e^(-.06x.25))
is $40, the strike price is $46, the risk-free interest rate is 6% and the continuously compounded dividend
yield is 2%?
$5.04 = 46e^(-.06x.5) – 40e^(-.02x.5)
10.8. The price of a European call option on a non-dividend paying stock with a strike price of $50 is $6. The
stock price is $51, the risk-free interest rate is 6% and the time to maturity is 1 year. What is the price of a 1-
year European put option on the stock with a strike price of $50?
$2.09 since 6-P = 51 – 50e^(-.06) implies P = 2.09
10.9. The price of a European call option on a stock, which will pay a dividend per share of $1 3 months from
now, is $6. The strike price is $50. The stock price is $51, the riskfree interest rate is 6% and the time to
maturity is 1 year. What is the price of a 1-year European put option on the stock?
$3.07 since 6-P = 51 - 1 e^-(.06x.25) – 50 e^(-.06) implies P = 3.07
10.10. The price of a European call option on a stock, which pays a continuously compounded dividend yield
of 2%, is $6. The strike price is $50. The stock price is $51, the risk-free interest rate is 6% and the time to
maturity is 1 year. What is the price of a 1-year European put option on the stock?
$3.10 since 6-P = 51e^(-.02) – 50e^(-.06) implies P = 3.10
10.11. A call and a put on a stock have the same strike price and time to maturity. Both options are
European. At 11AM on a certain day, the price of the call is $3 and the price of the put is $4. At 11:01 AM
news reaches the market that results in an increase in the volatility of the stock with no additional effects on
either the stock price or the risk-free interest rate. The price of the call option rises to $4.50. What would
you expect the price of the put to change to?
$5.50 since 4.50 –P = -1 = S – Xe^(-RxT) implies P = 5.50
10.12. The exercise price of a European put option on a single stock, which is currently trading at $45 per
share, is $50. The sole dividend per share envisioned during the 6month life of the option is $2 to be paid
3 months from now. The interest rate is 6% continuously compounded and the put premium equals $4.
Specify associated dollar amounts in your answers to the following questions: A.) What transactions now
will generate arbitrage profits?
The lower bound for the put premium is violated: p ≥ Ke−rt − (S − D)

4 ≥ ?50e−6%(.5) − (45−1.97)
4 < 5.49
Gap = 5.49 – 4 = $1.49 is the arbitrage profit that can be generated now.
Buy put -$4

Borrow $48.52 = 50 e^-(6%x0.5)
Borrow $1.97 = 2 e^-(6%x0.25) Total amount borrowed = 50.49
178
Buy stock -$45
Profit = $1.49
Note: After 3 months, use dividend received of $2 to pay off borrowing $1.97.
B.) What transactions 6 months from now will generate arbitrage profits?
If St < $50
Exercise put, obtain $50
Payoff loan of $48.52 -50
Profit = 0
If St > $50
Allow put to lapse unexercised
Sell stock St
Payoff loan of $48.52 -50
Profit = (St – 50)
Chapter 11: Trading Strategies Involving Options
11.1 6-month European call options with strike prices of $35 and $40 cost $6 and $4, respectively.
A.) What is the maximum gain or profit when a bull spread is created from the calls?
$3. See graph below.
B.) What is the maximum loss (negative profit) when a bull spread is created from the calls?
C.) Under what conditions regarding P, the stock price 6 months from now, will profits be generated from the
indicated bull spread?
When P exceeds $37. See graph below.
179
3
35
40
-2
D.) What is the maximum gain or profit when a bear spread is created from the calls?
E.) What is the maximum loss (negative profit) when a bear spread is created from the calls?
F.) Under what conditions regarding P, the stock price 6 months from now, will profits be generated from the
indicated bear spread?
When P is less than $37. See graph below.
35 40
-3
11.2 6-month European put options with strike prices of $55 and $65 cost $8 and $10, respectively.
180
A.) What is the maximum gain when a bull spread is created from the puts?
B.) What is the maximum loss when a bull spread is created from the puts?
C.) Under what conditions regarding P, the stock price 6 months from now, will profits be generated from the
indicated bull spread?
When the stock price 6 months from now exceeds $63. See graph below.
55
65
-8
11.3.A 3-month call with a strike price of $25 costs $2. A 3-month put with a strike pride of $20 costs
$3. A trader uses the options to create a strangle. For what 2 values of the stock price 3
months from now will the trader breakeven?
$15 and $30. See graph below.
15 20 25 30
181
11.4.A speculator decides to create a butterfly spread involving the following 3 one-year European
call options on a stock with exercise prices (and corresponding call premia in parentheses): $40
(premium $3), $45 (premium $2.30) and $50 (premium $2). For what values of the yearend
stock price, denoted P, will profits be generated?
Profit if $40.40 < P < $49.60

The first horizontal intercept occurs at $40 + $0.4 = $40.40
The second horizontal intercept occurs at $50 -$0.4 = $49.60
Profit is generated if the yearend stock price, i.e., P, is between these two values.
4.60
40 50
-0.4
The following is an example of what I refer to in the slides as a strangle not!
11.5.A speculator purchases a put option with exercise price of $100 and a premium of
$15 and a call option with exercise price of $80 and a premium of $10. The options are European, involve
one share in Y Corp., and expire a year from now. For what values of the yearend stock price will the
speculator generate a positive profit?
182
Profit generated if yearend stock price is less than $75 or greater than $105.
In the following graph, the up-front portfolio premium equals $25. The yearend stock price is plotted on the
horizontal axis. The upper graph depicts the payoff diagram whereas the bottom graph depicts the profit
diagram. Recall that profit = payoff – upfront premium.
20
80 100
75 105
-5
Chapter 12: Introduction to Binomial Trees
12.1. Consider a 6-month European put option on a non-dividend paying stock with a strike price of $32. The
current stock price is $30 and over the next 6 months it is expected to rise to $36 or fall to $27. The risk-free
interest rate is 6%.
A.) What is the risk-neutral probability of the stock rising to $36?
0.435 = (1.0305 - .9) / (1.2 - .9) where u = 1.2; d=.9; e^RT = 1.0305
B.) What position in the stock is necessary to hedge a long position in 1 put option?
Long position or own 0.556 share. Delta = (0 – 5) / (36 – 27) = -.556. Delta is the number of shares that
must be owned to hedge a short position in a put option. Since we are trying to hedge a long position in one
put, the appropriate position in the stock is .556.
C.) What is the value of a put option?
$2.74 via risk-neutral valuation. 2.74 = (e^-.06x.5) [.565x5]
D.) Assume now that the option is a call option rather than a put option. What position in the stock is
necessary to hedge a long position in 1 call option?
Short position or issue 0.444 share. Delta = (4 - 0) / (36 – 27) = .444. If you issue a call option, you hedge
by owning .444 share. Thus, if you own a call option, you must short .444 share.
E.) What is the value of a call option?

183
$1.69 Via risk-neutral valuation 1.69 = (e^-.06X.5) [.435x4]. Via put-call-parity C =
2.74 + 30 – 32(e^-.06x.5) = 1.69
12.2. A power option pays off [max(St – K), 0]^2 at time t where St is the stock price at time t and K is the
strike price. Note: Since the indicated payoff is merely the squared value of the payoff on a traditional call
option, a power option may be considered a call option on steroids. Consider a situation where K=26 and t is
one year. The stock price is currently $24 and at the end of one year, it will be either $30 or $18. The risk-
free rate is 5%.
A.) What is the risk-neutral probability of the stock rising to $30?
0.603 = (1.05127 - .75) / (1.25 - .75) where u = 1.25; d = .75; e^Rt = 1.05127
B.) What position in the stock is required to hedge a short position in one power option?
Long position in 1.333 shares. Delta = (16 - 0) / (30-18) = 1.333.
C.) What is the value of the power option?
$9.17 = (e^-.05) [.6025x16] via risk-neutral valuation.
12.3. A stock price is currently $100. The stock pays no dividend. Over each of the next two 3-month
periods, it is expected to increase by 10% or fall by 10%; the preceding percentages are not annualized.
Consider a 6-month European put option with a strike price of $95. The risk-free rate is 8%.
A.) What is the risk-neutral probability of a 10% rise in a single quarter?
.601 = (1.0202 - .9) / (1.1 - .9)
B.) What is the value of the option?
$2.14. Refer to the following diagram. Following the notational convention in the textbook, the upper
number at each node refers to the value of the stock and the lower number refers to the value of the option.
121
0
110
0
99
100 0
2.14
90
5.475
81
14
184
C.) If the put option were American rather than European, what would its value be? $2.14. Inspection of the
3-month or intermediate nodes shows that it would never be optimal to prematurely exercise the put.
Thus, in this case, the value of the American put equals the value of the otherwise identical European
put.
D.) Assume now that the option is a European call rather than a European put. What is the value of the
option?
$10.87. Refer to the following diagram.
121
26
110
16.88
99
100 4
10.87
90
2.356
81
0
An alternative way of valuing the call option is to invoke put-call parity, C = 10.87 = 2.14 +100 – 95
e^(-.08x.5).
Note that the call option values at the end of one quarter, i.e. 16.88 and 2.356, are obtained via risk-neutral
valuation. Thus, for example, 2.356 = e^(-.08x.25) [.601x4].
E.) Assume now that the call option is American rather than European. What is the value of the option?
$10.87. It is never optimal to prematurely exercise an American call option on a nondividend paying stock.
Thus, the value of this American call option equals the value of an otherwise identical European call option.
12.4. A common stock that pays no dividend has a price that currently equals $50. At the end of 3
months the stock price can either rise to $54 or drop to $47. The risk-free interest rate is 10% per
annum compounded continuously. Consider a 3-month European call option on 100 shares with a
strike price of $49. To hedge the writing of such an option, what position must be taken in the
underlying stock?
Δ= =.714 .71=
Must purchase or take a long position in 71 shares of the underlying stock.
Note: Call value in up state (stock price = 54) is 5. Call value in down state (stock price = 47) is 0.
185
12.5. A common stock that pays no dividend has a price that currently equals $50. At the end of 3
months the stock price can either rise to $54 or drop to $47. The risk-free interest rate is 10% per
annum compounded continuously. Consider a 3-month European put option on 100 shares with a
strike price of $49. To hedge the writing of such an option, what position must be taken in the
underlying stock?
T = .25, r = 10%, K = 49
− fd 0−2
Δ= fu = =−.2857 ≈−.29
Su − Sd 54 − 47
Must take a long position in -29 share or a short position in 29 shares.
54
0
50
47
2
Chapter 13: Valuing Stock Options: The Black-Scholes-Merton Model
13.1. For a European call option on a non-dividend-paying stock, the stock price is $30, the strike price is
$29, the risk-free interest rate is 6%, the volatility is 20% per annum and the time to maturity is 3 months.
Express you answers in terms of the N(d), i.e., calculate d but do not calculate N(d).
A.) What is the price of the option?
30N(.539) – 28.57 N(.439) since c = 30 N(d1) – 29 e^(-.06x.25) N(d2) where d1 = ( ln(30/29) + (.06
+ (.2^2)/2 ).25 / (.2 (.25)^.5) and d2 = d1 - (.2 (.25)^.5)
B.) What is the price of the option if it were American rather than European?
186
Same as part A.) since it is never optimal to prematurely exercise an American call option on a non-dividend
paying stock.
C.) What is the price of the option is if it is a put?
28.57N(-.439) – 30N(-.539)
D.) What is the price of the option if a dividend of $2 is expected in 2 months?
28.02N(-.1438) – 28.57 N(-.2438) since in part A.) instead of the stock price of $30 we substitute the stock
price minus the present value of the dividend, i.e. 30 – 2e^(.06x.1666) = $28.02
13.2. The underlying stock of a 6-month American call option will pay a dividend at the end of 5 months. The
strike price is $30 and the risk-free rate is 10%. How high must the dividend per share be for there to be
some chance of early exercise?
$0.25 = 30 (.1) ((6-5)/12) Note: This formula is the last inequality found in the Appendix to Chapter 13 on
page 313.
The dividend per share must exceed $0.25 for there to be a possibility of optimal exercise of the call option
immediately before the ex-dividend date 5 months from now, i.e. early exercise.
The following is an explanation of the formula:
There is no chance of early exercise if the DPS (dividend per share) is less than a certain critical value. In
this situation, you can rule out the possibility that the option will be exercised early.
That critical value is calculated as follows: strike price x risk-free rate x time span between the date of the last
dividend payment and the expiration date of the option. Time is measured in years.
If the DPS exceeds the critical value, there is some chance that the call will be exercised early, i.e., one
cannot rule out the possibility of early exercise.
Early exercise means that the call option will be exercised before the expiry of the option.
13.3. A call option on one share has one year to expiration and stipulates an exercise price of $60. The
underlying stock is currently trading at $50 per share, exhibits a volatility of 30%, and pays no dividend. The
risk-free interest rate is 6% continuously compounded. The option is European.
A.) What is the risk neutral probability that the option will be exercised?
50 .32
ln( ) + (.06 − )1
2
60
d2 = .31 =−.5577
N( .5577)−
187
B.) If a hedge fund were to write a call option on 100 shares of the underlying common stock, what position
must the fund take in the underlying stock to form a riskless or arbitrage portfolio?
d1 = d2 +σ T
d1 =−.5577 +.3 1 =−.2577
N d( 1) = N( .2577)−
The hedge fund must hold a long position in 100N(-.2577) shares of the underlying common stock.
13.4. A European put option that expires in 3 months stipulates a strike price of $70 per share. The
underlying common stock is currently trading at $75 per share and exhibits a volatility of 35%. The risk-free
interest rate is 5% continuously compounded. The only dividend that will be paid during the life of the option
is $3 per share that is payable two months from now.
A.) What is the risk neutral probability that the put option will be exercised?
D = 3e−.05(2/12) = 2.975
75− 2.975 ⎛ .352 ⎞
ln( ) +⎜.05− ⎟.25
2
d= 0.1468
N(−d2 ) = N( .1468)− ≈ .44
Note: In both the quizzes and the final exam, you will not be asked to read probabilities off a normal
probability table. In this specific case, the required answer will be N(-0.1468), not approximately 0.44.
B.) If a hedge fund were to write a put option on 100 shares of the common stock, want position in the
common stock must the hedge fund establish to form a riskless or arbitrage portfolio?
d1 = d2 +σ T
d1 = .1468+.35 .25 = .3218
N(−d1) = N( .3218)−
Recall that the delta of a put on one common stock equals –N(-d1). Thus, to hedge the issuance of a put on
one common stock, the hedge fund must take a long position in –N(-d1) shares of the underlying stock, i.e.,
the fund must take a short position in N(-d1) shares of the underlying stock.
Thus, the hedge fund must take a short position in 100N(-.3218) shares of the underlying common stock.
Chapter 15: Options on Stock Indices and Currencies
15.1. Consider a European put option on a stock index. The index level is 1,000, the strike price is 1,050, the
time to maturity is 6 months, the risk-free rate is 4% and the dividend yield on the index is 2%. What is the
lower bound to the option price?
$39.16 = 1050e^(-.04x.5) – 1000e^(-.02x.5)
188
15.2. Consider a European call option on a stock index. The index level is 1,000, the strike price is 900, the
time to maturity is 6 months, the risk-free rate is 4% and the dividend yield on the index is 2%. What is the
lower bound to the option price?
$107.87 = 1000e^(-.02x.5) – 900 e^(-.04x.5)
15.3. Consider a 1-year European call option on a currency. The exchange rate is $1.0000, the strike price
is $0.9100, the domestic risk-free rate is 5%and the foreign riskfree rate is 3%. What is the lower bound to
the option price?
$0.1048 = 1.000e^(-.03) – 0.9100e^(-.05)
15.4. An exchange rate is currently $0.8. It is expected to move up to $0.84 or down to $0.76 in the next 3
months. The risk-free rates in the domestic and foreign currencies are 4% and 6%, respectively.
A.) What is the probability of an up movement in a risk-neutral world?
0.4501 = (e^(.04-.06)x.25 - .95) / (1.05 - .95) where u = 1.05 and d = .95
B.) What is the value of a 3-month European call option with a strike price of $0.82?
$.0089 = e^(-.04x.25) [.4501 (.02) ]
C.) What is the value of a 3-month European put option with a strike price of $0.82?
$.0327 = e^(-.04x.25) [.5499 (.06) ] where the probability of a down movement = .5499
15.5. A stock index currently equals 1,000. Its volatility is 20%. The risk-free rate is 4% and the dividend
yield on the index is 2%. Express you answers in terms of N(d), i.e. calculate d but do not calculate N(d).
A.) What is the value of a 1-year European call option with a strike price of 950?
980.20 N(.4565) – 912.75 N(.2565) = 1000e^(-.02) N(d1 ) – 950 e^(-.04) N(d2)

Where d1 = (ln(1000/950) + (.04 - .02 + .2^2/2)) / .2 and d2 = d1 - .2
B.) What is the value of a 1-year European put option with a strike price of 950?
912.75 N(-.2565) – 980.2 N(-.4565) = 950 e^(-.04) N(-d2) - 1000e^(-.02) N(-d1 )
15.6. A portfolio manager in charge of a portfolio worth $10 million is concerned that the market might decline
rapidly during the next 6 months and would like to use options on the S&P 100 to provide protection against
the portfolio falling below $9.5 million. The S&P 100 index is currently standing at 500 and each contract is
on 100 times the index. Assume dividend yields equal zero on both the portfolio and the stock index.
A.) If the portfolio has a beta of 1, how many put option contracts should be purchased?
200 = 1 (10M/500x100)
189
B.) If the portfolio has a beta of 1, what should be the strike price of the put options?
475 since [9.5/10 - 1 – R] = 1 [ K/500 - 1 – R] implies K = 475. R is the redundant 6month risk-free rate.
Note that R is redundant if and only if the beta of the portfolio equals 1, because R cancels out from both
sides of the equation.
C.) If the portfolio has a beta of 0.5, how many put option contracts should be purchased?
100 = .5 (10M/500x100)
D.) If the portfolio has a beta of 0.5, what should be the strike price of the put option? Assume that the risk-
free rate is 10% and the dividend yield on both the portfolio and the index is 2%, where both interest rates
and dividend yields are quoted with semi-annual compounding.
430 since [(9.5/10 -1) +.01 - .05] = .5 [(K/500 -1) +.01 - .05] implies K = 430
15.7. A stock portfolio, whose beta equals 1.8, is worth $50 million and the S&P 500 Index is at 1,350. The
dividend yield on both the portfolio and the index equals 2.5% while the risk-free interest rate equals 6%,
both numbers expressed with annual compounding. How would you ensure that the yearend ex-dividends
value of the portfolio not fall below $43 million?
50M
NumberPuts =1.8 = 667Puts
1350(100)
⎡43M ⎤ ⎡K ⎤⎢ 50M − +1 .025−.06⎥⎦ =1.8⎢⎣1350 −
+1 .025−.06⎥⎦
⎣
K =1266
Purchase 667 puts with strike price of $1,266.
*Ex. 17-127—Fair value hedge.
On January 2, 2013, Tylor Co. issued a 4-year, $750,000 note at 6% fixed interest, interest payable
semiannually. Tylor now wants to change the note to a variable rate note. As a result, on January 2, 2013,
Tylor Co. enters into an interest rate swap where it agrees to receive 6% fixed and pay LIBOR of 5.6% for the
first 6 months on $750,000. At each 6-month period, the variable interest rate will be reset. The variable rate
is reset to 6.6% on June 30, 2013.
Instructions
(a) Compute the net interest expense to be reported for this note and related swap transaction as of June 30,
2013.
190
(b) Compute the net interest expense to be reported for this note and related swap transaction as of
December 31, 2013.
*Solution 17-127
(a) and (b)
6/30/13 12/31/1
3
Fixed-rate debt $750,000 $750,0
00
Fixed rate (6% ÷ 2) 3% 3%
Semiannual debt payment $ 22,500 $
22,500
Swap fixed receipt 22,500
22,500
Net income effect $ 0 $ 0
Swap variable rate
5.6% × ½ × $750,000 $ 21,000
6.6% × ½ × $750,000 0 $
24,750
Net interest expense $ 21,000 $
24,750
*Ex. 17-128—Cash flow hedge.
On January 2, 2012, Sloan Company issued a 5-year, $6,000,000 note at LIBOR with interest paid annually.
The variable rate is reset at the end of each year. The LIBOR rate for the first year is 6.8%
Sloan Company decides it prefers fixed-rate financing and wants to lock in a rate of 6%. As a result, Sloan
enters into an interest rate swap to pay 7% fixed and receive LIBOR based on $8 million. The variable rate is
reset to 7.4% on January 2, 2013.
Instructions
(a) Compute the net interest expense to be reported for this note and related swap transactions as of
December 31, 2012.
(b) Compute the net interest expense to be reported for this note and related swap transactions as of
December 31, 2013.
*Solution 17-128
(a) and (b)
12/31/12 12/31/13
Variable-rate debt $6,000,000 $6,000,00
0
Variable rate 6.8% 7.4%
Debt payment $ 408,000 $ 444,000
Debt payment $ 408,000 $ 444,000

Swap receive variable (408,000) (444,000)
Net income effect $ 0 $ 0
Swap payable—fixed 420,000 420,000
Net interest expense $ 420,000 $ 420,000
*Pr. 17-132—Derivative financial instrument.

Hummel Co. purchased a put option on Olney common shares on July 7, 2012, for $100. The put option is for
200 shares, and the strike price is $30. The option expires on January 31, 2013. The following data are
191
Date Market Price of Olney Shares Time Value of Put Option
September 30, 2012 $32 per share $55 December 31, 2012 $31 per share 21
January 31, 2013 $33 per share 0
Instructions
Prepare the journal entries for Hummel Co. for the following dates:
(a) July 7, 2012—Investment in put option on Olney shares.
(b) September 30, 2012— Hummel prepares financial statements.
(c) December 31, 2012— Hummel prepares financial statements.
(d) January 31, 2013—Put option expires.
*Solution 17-132
July 7, 2012
(a) Put Option..................................................................................... 100
Cash ................................................................................. 100
September 30, 2012

(b) Unrealized Holding Gain or Loss—Income .................................. 45
Put Option ($100 – $55) ................................................... 45
December 31, 2012

(c) Unrealized Holding Gain or Loss—Income .................................. 34
Put Option ($55 – $21) ..................................................... 34
January 31, 2013

(d) Loss on Settlement of Put Option................................................. 21
Put Option ($21 – $0) ....................................................... 21
*Pr. 17-133—Free-standing derivative.

Welch Co. purchased a put option on Reese common shares on January 7, 2013, for $215. The put option is
for 300 shares, and the strike price is $51. The option expires on July 31, 2013. The following data are
Date Market Price of Reese Shares Time Value of Put

Option
March 31, 2013 $47 per share $120
June 30, 2013 $50 per share 56
July 6, 2013 $46 per share 16
*Pr. 17-133 (cont.)
192
Instructions
Prepare the journal entries for Welch Co. for the following dates:
(a) January 7, 2013—Investment in put option on Reese shares.
(c) March 31, 2013— Welch prepares financial statements.
(d) June 30, 2013— Welch prepares financial statements.
(e) July 6, 2013— Welch settles the call option on the Reese shares.
*Solution 17-133
January 7, 2013
(a) Put Option..................................................................................... 215
Cash.................................................................................. 215
March 31, 2013

(b) Put Option..................................................................................... 1,200
Unrealized Holding Gain or Loss—Income ($4 × 300)...... 1,200

Put Option ($215 – $120).................................................. 95
June 30, 2013
Put Option ($3 × 300)........................................................ 900

Put Option ($120 – $56).................................................... 64
July 6, 2013
(d) Unrealized Holding Gain or Loss—Income................................... 40
Put Option ($56 – $16)...................................................... 40
Cash (300 × $5) ............................................................................ 1,500

Gain on Settlement of Put Option...................................... 1,184 Put
Option*........................................................................ 316
*Value of Put Option settlement:
Put Option
193
215
1,200 95
900
64
40
316
84. Morgan Manufacturing Company has the following account balances at year end:
Office supplies $
4,000
Raw materials 27,0
00
Work-in-process 59,0
00
Finished goods 82,0
00
Prepaid insurance 6,000
What amount should Morgan report as inventories in its balance sheet? a. $82,000.
b. $86,000.
c. $168,000.
d. $172,000.
$27,000 + $59,000 + $82,000 = $168,000.
85. Lawson Manufacturing Company has the following account balances at year end:
Office supplies $
4,000
Raw materials 27,0
00
Work-in-process 59,0
00
Finished goods 97,0
00
Prepaid insurance 6,000
What amount should Lawson report as inventories in its balance sheet? a. $97,000.
b. $101,000.
c. $183,000.
d. $187,000.
$27,000 + $59,000 + $97,000 = $183,000.
86. Elkins Corporation uses the perpetual inventory method. On March 1, it purchased $20,000 of
inventory, terms 2/10, n/30. On March 3, Elkins returned goods that cost $2,000. On March 9, Elkins
paid the supplier. On March 9, Elkins should credit a. purchase discounts for $400.
b. inventory for $400.
c. purchase discounts for $360.
d. inventory for $360.
[($20,000 – $2,000) × .02] = $360.
87. Malone Corporation uses the perpetual inventory method. On March 1, it purchased $50,000 of
inventory, terms 2/10, n/30. On March 3, Malone returned goods that cost $5,000. On March 9, Malone
paid the supplier. On March 9, Malone should credit a. purchase discounts for $1,000.
b. inventory for $1,000.
c. purchase discounts for $900.
d. inventory for $900.
[($50,000 – $5,000) × .02] = $900.
88. Bell Inc. took a physical inventory at the end of the year and determined that $780,000 of goods were
on hand. In addition, Bell, Inc. determined that $60,000 of goods that were in transit that were shipped
f.o.b. shipping point were actually received two days after the inventory count and that the company
had $90,000 of goods out on consignment. What amount should Bell report as inventory at the end of
the year? a. $780,000.
b. $840,000.
c. $870,000.
d. $930,000.
194
$780,000 + $60,000 + $90,000 = $930,000.
89. Bell Inc. took a physical inventory at the end of the year and determined that $760,000 of goods were
on hand. In addition, the following items were not included in the physical count. Bell, Inc. determined
that $96,000 of goods were in transit that were shipped f.o.b. destination (goods were actually received
by the company three days after the inventory count).The company sold $40,000 worth of inventory
f.o.b. destination. What amount should Bell report as inventory at the end of the year? a. $760,000.
b. $856,000.
c. $800,000.
d. $896,000.
$760,000 + $40,000 = $800,000.
90. Risers Inc. reported total assets of $1,800,000 and net income of $200,000 for the current year. Risers
determined that inventory was overstated by $15,000 at the beginning of the year (this was not
corrected). What is the corrected amount for total assets and net income for the year?
a. $1,800,000 and $200,000.
b. $1,800,000 and $215,000.
c. $1,785,000 and $185,000.
d. $1,815,000 and $215,000.
$1,800,000 and ($200,000 + $15,000) = $215,000.
91. Risers Inc. reported total assets of $3,200,000 and net income of $170,000 for the current year. Risers
determined that inventory was understated by $46,000 at the beginning of the year and $20,000 at the
end of the year. What is the corrected amount for total assets and net income for the year?
a. $3,220,000 and $190,000.
b. $3,180,000 and $196,000.
c. $3,220,000 and $144,000.
d. $3,200,000 and $170,000.
($3,200,000 + $20,000) and ($170,000 – $46,000 + $20,000) = $144,000.
Hudson, Inc. is a calendar-year corporation. Its financial statements for the years 2013 and 2012 contained
errors as follows:
2013 2012
Ending inventory $4,500 overstated $12,000
overstated
Depreciation expense $3,000 understated $9,000
overstated
92. Assume that the proper correcting entries were made at December 31, 2012. By how much will 2013
income before taxes be overstated or understated? a. $1,500 understated
b. $1,500 overstated
c. $3,000 overstated
d. $7,500 overstated
$4,500 + $3,000 = $7,500.
93. Assume that no correcting entries were made at December 31, 2012. Ignoring income taxes, by how
much will retained earnings at December 31, 2013 be overstated or understated?
a. $1,500 understated
c. $7,500 understated
d. $13,500 understated
$9,000 – ($4,500 + $3,000) = $1,500.
94. Assume that no correcting entries were made at December 31, 2012, or December 31, 2013 and that
no additional errors occurred in 2014. Ignoring income taxes, by how much will working capital at
December 31, 2014 be overstated or understated?
a. $0
c. $3,000 understated
d. $7,500 understated
The effect of the errors in ending inventories reverse themselves in the following year.
95. The following information is available for Naab Company for 2012:
195
Freight-in $ 30,000 Purchase returns 75,000 Selling expenses
200,000
Ending inventory 260,000
The cost of goods sold is equal to 400% of selling expenses. What is the cost of goods available for
sale? a. $800,000.
b. $1,090,000.
c. $1,015,000.
d. $1,060,000.
$260,000 + (4 × $200,000) = $1,060,000.
Winsor Co. records purchases at net amounts. On May 5 Winsor purchased merchandise on account,
$20,000, terms 2/10, n/30. Winsor returned $1,500 of the May 5 purchase and received credit on account. At
May 31 the balance had not been paid.
96. The amount to be recorded as a purchase return is
a. $1,350.
b. $1,530
c. $1,500.
d. $1,470.
$1,500 – ($1,500 × .02) = $1,470.
97. By how much should the account payable be adjusted on May 31? a. $0.
b. $430.
c. $400.
d. $370.
($20,000 – $1,500) × .02 = $370.
The following information was available from the inventory records of Rich Company for January:
Units Unit Cost Total
Cost
Balance at January 1 3,000 $9.77 $29,31
Purchases: 0
January 6 2,000 10.30 20,600
January 26 2,700 10.71 28,917
Sales:
January 7 (2,500)
January 31 (4,300)
Balance at January 31 900
98. Assuming that Rich does not maintain perpetual inventory records, what should be the inventory at
January 31, using the weighted-average inventory method, rounded to the nearest dollar? a. $9,454.
b. $9,213.
c. $9,234.
d. $9,324.
($29,310 + $20,600 + $28,917) ÷ (3,000 + 2,000 + 2,700) = $10.237/unit
$10.237 × 900 = $9,213.
99. Assuming that Rich maintains perpetual inventory records, what should be the inventory at January 31,
using the moving-average inventory method, rounded to the nearest dollar?
a. $9,454.
b. $9,213.
c. $9,234.
d. $9,324.
2 Avg. on 1/6 $49,910 ÷ 5,000 = $9.982/unit 1/26 $53,872 ÷ 5,200 = $10.36/unit
$10.36 × 900 = $9,324.
196
Niles Co. has the following data related to an item of inventory:
Inventory, March 1 100 units @ $2.10 Purchase, March 7 350 units @ $2.20
Purchase, March 16 70 units @ $2.25
Inventory, March 31 130 units
100. The value assigned to ending inventory if Niles uses LIFO is

a. $290.
b. $276.
c. $273.
d. $292.
(100 × $2.10) + (30 × $2.20) = $276.
101. The value assigned to cost of goods sold if Niles uses FIFO is
a. $290.
b. $276.
c. $862.
d. $848.
100 + 350 + 70 – 130 = 390 units
(100 × $2.10) + (290 × $2.20) = $848.
102. Emley Company has been using the LIFO method of inventory valuation for 10 years, since it began
operations. Its 2012 ending inventory was $60,000, but it would have been $90,000 if FIFO had been
used. Thus, if FIFO had been used, Emley's income before income taxes would have been
a. $30,000 greater over the 10-year period.
b. $30,000 less over the 10-year period.
c. $30,000 greater in 2012.
d. $30,000 less in 2012.
($90,000 – $60,000) = $30,000.
Transactions for the month of June were:
Purchases Sales
June 1 (balance) 1,200 @ $3.20 June 2 900 @ $5.50
3 3,300 @ 3.10 6 2,400 @ 5.50
7 1,800 @ 3.30 9 1,500 @ 5.50 15 2,700 @ 3.40 10
600 @ 6.00
22 750 @ 3.50 18 2,100 @ 6.00
25 300 @ 6.00
103. Assuming that perpetual inventory records are kept in units only, the ending inventory on a LIFO basis
is a. $6,165.
b. $6,240.
c. $6,435.
d. $6,705.
Available (purchases) = 9,750 units
Sales = 7,800 units
EI = 9,750 – 7,800 = 1,950 units
(1,200 × $3.20) + (750 × $3.10) = $6,165.
104. Assuming that perpetual inventory records are kept in dollars, the ending inventory on a LIFO basis is
a. $6,165.
b. $6,240.
c. $6,435.
d. $6,705.
104. c (300 × $3.2) + (600 × $3.1) + (600 × $3.4) + (450 × $3.5) = $6,435.
197
Date Purchase Sold Balance
6/1 (1,200 @ 3.2) 3,840 (1,200 @ 3.2) 3,840
6/2 (900 @ 3.2) 2,880 (300 @ 3.2) 960
6/3 (3,300 @ 3.1) 10,230 (300 @ 3.2)
(3,300 @ 3.1)
11,190
6/6 (2,400 @ 3.1) 7,440 (300 @ 3.2)
(900 @ 3.1) 3,750
6/7 (1,800 @ 5,940 (300 @ 3.2)
3.3)
(900 @ 3.1)
(1,800 @ 3.3) 9,690
6/9 (1,500 @ 3.3) 4,950 (300 @ 3.2)
(900 @ 3.1)
(300 @ 3.3) 4,740
6/10 (300 @ 3.3) (300 @ 3.2)
(300 @ 3.1) 1,920 (600 @ 3.1) 2,820
6/15 (2,700 @ 9,180 (300 @ 3.2)
3.4)
(600 @ 3.1)
(2,700 @ 3.4)
12,000
6/18 (2,100 @ 3.4) 7,140 (300 @ 3.2)
(600 @ 3.1) 4,860
(600 @ 3.4)
6/22 (750 @ 3.5) 2,625 (750 @ 3.5) 7,485
6/25 (300 @ 3.5) 1,050 (300 @ 3.2)
(600 @ 3.1)
(600 @ 3.4)
(450 @ 3.5) 6,435
105. Assuming that perpetual inventory records are kept in dollars, the ending inventory on a FIFO basis is
a. $6,165.
b. $6,240.
c. $6,435.
d. $6,705.
(750 × $3.5) + (1,200 × $3.4) = $6,705.
106. Assuming that perpetual inventory records are kept in units only, the ending inventory on an average-
cost basis, rounded to the nearest dollar, is a. $6,144.
b. $6,357.
c. $6,435.
d. $6,483.
$31,815 ÷ 9,750 units = $3.26
$3.26 × 1,950 = $6,357.
107. Milford Company had 500 units of “Tank” in its inventory at a cost of $4 each. It purchased, for $2,800,
300 more units of “Tank”. Milford then sold 400 units at a selling price of $10 each, resulting in a gross
profit of $1,600. The cost flow assumption used by
Johnson
a. is FIFO.
b. is LIFO.
c. is weighted average.
d. cannot be determined from the information given.
(400 × $10) – $1,600 = $2,400 COGS

[(500 × $4) + $2,800] – $2,400 = $2,400 E.I.
198
($4,800 ÷ 800) × 400 units = $2,400 E.I. under weighted avg.
108. Nichols Company had 500 units of “Dink” in its inventory at a cost of $5 each. It purchased, for $2,400,
300 more units of “Dink”. Nichols then sold 600 units at a selling price of $10 each, resulting in a gross
profit of $2,100. The cost flow assumption used by Nichols.
a. is FIFO.
b. is LIFO.
c. is weighted average.
d. cannot be determined from the information given.
(600 $10) – $2,100 = $3,900 COGS
[(500 $5) + $2,400] – $3,900 = $1,000 E.I.
200 × $5 = $1,000 E.I. under LIFO.
109. June Corp. sells one product and uses a perpetual inventory system. The beginning inventory
consisted of 20 units that cost $20 per unit. During the current month, the company purchased 120
units at $20 each. Sales during the month totaled 90 units for $43 each. What is the number of units in
the ending inventory? a. 20 units.
b. 30 units.
c. 50 units.
d. 140 units.
20 + 120 – 90 = 50 units.
110. June Corp. sells one product and uses a perpetual inventory system. The beginning inventory
consisted of 20 units that cost $20 per unit. During the current month, the company purchased 120
units at $20 each. Sales during the month totaled 90 units for $43 each. What is the cost of goods sold
using the LIFO method? a. $400.
b. $1,800.
c. $2,400.
d. $3,870.
90 × $20/unit = $1,800.
111. Checkers uses the periodic inventory system. For the current month, the beginning inventory consisted
of 2,400 units that cost $12 each. During the month, the company made two purchases: 1,000 units at
$13 each and 4,000 units at $13.50 each. Checkers also sold 4,300 units during the month. Using the
average cost method, what is the amount of cost of goods sold for the month? a. $55,685.
b. $57,900.
c. $53,950.
d. $55,900.
[(2,400 × $12) + (1,000 × $13) + (4,000 × $13.50] ÷ (2,400 + 1,000 + 4,000) =
$12.95; $12.95 × 4,300 = $55,685.
112. Chess Top uses the periodic inventory system. For the current month, the beginning inventory
consisted of 300 units that cost $65 each. During the month, the company made two purchases: 450
units at $68 each and 225 units at $70 each. Chess Top also sold 750 units during the month. Using
the average cost method, what is the amount of ending inventory?
a. $15,750.
b. $50,655.
c. $50,100.
d. $15,197.
[(300 × $65) + (450 × $68) + (225 × $70)] ÷ (300 + 450 + 225) = $67.54;
$67.54 × (975 – 750) = $15,197.
FIFO method, what is the ending inventory?
a. $40,146.
b. $37,200.
c. $41,850.
d. $37,900.
(2,400 + 1,000 + 4,000) – 4,300 = 3,100; 3,100 × $13.50 = $41,850.
199
the FIFO method, what is the amount of cost of goods sold for the month? a. $50,655.
b. $48,750.
c. $51,225.
d. $50,100.
(300 × $65) + [(750 – 300) × $68] = $50,100.
LIFO method, what is the ending inventory?
a. $40,146.
b. $37,200.
c. $41,850.
d. $37,900.
(2,400 + 1,000 + 4,000) – 4,300 = 3,100;
(2,400 × $12) + [(3,100 – 2,400) × $13] = $37,900.
the LIFO method, what is the amount of cost of goods sold for the month? a. $50,655.
b. $48,750.
c. $51,225.
d. $50,100.
(225 × $70) + (450 × $68) + (75 × $65) = $51,225.
117. Black Corporation uses the FIFO method for internal reporting purposes and LIFO for external
reporting purposes. The balance in the LIFO Reserve account at the end of 2012 was $100,000. The
balance in the same account at the end of 2013 is $150,000. Black’s Cost of Goods Sold account has
a balance of $750,000 from sales transactions recorded during the year. What amount should Black
report as Cost of Goods Sold in the 2013 income statement? a. $700,000.
b. $750,000.
c. $800,000.
d. $900,000.
$750,000 + ($150,000 – $100,000) = $800,000.
118. White Corporation uses the FIFO method for internal reporting purposes and LIFO for external
reporting purposes. The balance in the LIFO Reserve account at the end of 2012 was $120,000. The
balance in the same account at the end of 2013 is $180,000. White’s Cost of Goods Sold account has
a balance of $900,000 from sales transactions recorded during the year. What amount should White
report as Cost of Goods Sold in the 2013 income statement? a. $840,000.
b. $900,000.
c. $960,000.
d. $1,080,000.
$900,000 + ($180,000 – $120,000) = $960,000.
119. Milford Company had 400 units of “Tank” in its inventory at a cost of $8 each. It purchased 600 more
units of “Tank” at a cost of $12 each. Milford then sold 700 units at a selling price of $20 each. The
LIFO liquidation overstated normal gross profit by a. $ -0-
b. $400.
c. $800.
d. $1,200.
[(700 – 600) × ($12 – $8)] = $400.
120. Nichols Company had 400 units of “Dink” in its inventory at a cost of $10 each. It purchased 600 more
units of “Dink” at a cost of $15 each. Nichols then sold 700 units at a selling price of $25 each. The
LIFO liquidation overstated normal gross profit by a. $ -0-
b. $500.
c. $1,000.
d. $1,500.
[(700 – 600) × ($15 – $10)] = $500.
Use the following information for 121 and 122
200
RF Company had January 1 inventory of $150,000 when it adopted dollar-value LIFO. During the year,
purchases were $900,000 and sales were $1,500,000. December 31 inventory at year-end prices was
$215,040, and the price index was 112.
121. What is RF Company’s ending inventory?
a. $150,000.
b. $192,000.
c. $197,040.
d. $215,040.
$215,040 ÷ 1.12 = $192,000 – $150,000 = $42,000.
$150,000 + ($42,000 × 1.12) = $197,040.
122. What is RF Company’s gross profit?
a. $642,000.
b. $647,040.
c. $665,190.
d. $1,302,960.
$150,000 + $900,000 – $197,040 = $852,960 COGS
$1,500,000 – $852,960 = $647,040.
Use the following information for 123 and 124
Hay Company had January 1 inventory of $120,000 when it adopted dollar-value LIFO. During the year,
purchases were $720,000 and sales were $1,200,000. December 31 inventory at yearend prices was
$151,800, and the price index was 110.
123. What is Hay Company’s ending inventory?
a. $132,000.
b. $138,000.
c. $139,800.
d. $151,800.
$151,800 ÷ 1.10 = $138,000 – $120,000 = $18,000.
$120,000 + ($18,000 × 1.10) = $139,800.
124. What is Hay Company’s gross profit?
a. $498,000.
b. $499,800.
c. $511,800.
d. $1,060,200.
$120,000 + $720,000 – $139,800 = $700,200 COGS
$1,200,000 – $700,200 = $499,800.
Gross Corporation adopted the dollar-value LIFO method of inventory valuation on December 31, 2011. Its
inventory at that date was $440,000 and the relevant price index was 100. Information regarding inventory for
subsequent years is as follows:
Inventory at Current
Date Current Prices Price Index

December 31, 2012 $513,600 107 December 31, 2013 580,000 125
December 31, 2014 650,000 130
125. What is the cost of the ending inventory at December 31, 2012 under dollar-value LIFO? a. $480,000.
b. $513,600.
c. $482,800.
d. $470,800.
$513,600 ÷ 1.07 = $480,000
$440,000 + [(480,000 – $440,000) × 1.07] = $482,800.
b. $462,800.
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c. $465,680.
d. $480,000.
$580,000 ÷ 1.25 = $464,000
($440,000 × 1) + ($24,000 × 1.07) = $465,680.
b. $509,600.
c. $500,000.
d. $526,800.
$650,000 ÷ 1.30 = $500,000
($440,000 × 1) + ($24,000 × 1.07) + ($36,000 × 1.3) = $512,480.
128. Wise Company adopted the dollar-value LIFO method on January 1, 2012, at which time its inventory
consisted of 6,000 units of Item A @ $5.00 each and 3,000 units of Item B @ $16.00 each. The
inventory at December 31, 2012 consisted of 12,000 units of Item A and 7,000 units of Item B. The
most recent actual purchases related to these items were as follows:
Quantity
Items Purchase Date Purchased Cost Per Unit

A 12/7/12 2,000 $ 6.00 A 12/11/12 10,000
5.75
B 12/15/12 7,000 17.00
Using the double-extension method, what is the price index for 2012 that should be computed by Wise
Company? a. 108.33%
b. 109.59%
c. 111.05%
d. 220.51%
[(2,000 × $6) + (10,000 × $5.75) + (7,000 × $17)] ÷ [(12,000 × $5) +
(7,000 × $16)] = 1.0959 = 109.59%.
129. Web World began using dollar-value LIFO for costing its inventory last year. The base year layer
consists of $350,000. Assuming the current inventory at end of year prices equals $483,000 and the
index for the current year is 1.10, what is the ending inventory using dollar-value LIFO? a. $483,000.
b. $448,000.
c. $439,091.
d. $531,300.
$483,000 ÷ 1.10 = $439,091; $439,091 – $350,000 = $89,091;
$350,000 + ($89,091 × 1.10) = $448,000.
130. Willy World began using dollar-value LIFO for costing its inventory two years ago. The ending
inventory for the past two years in end-of-year dollars was $120,000 and $180,000 and the year-end
price indices were 1.0 and 1.2, respectively. Assuming the current inventory at end of year prices
equals $258,000 and the index for the current year is 1.25, what is the ending inventory using dollar-
value LIFO? a. $213,000.
b. $223,680.
c. $228,000.
d. $226,500.
$258,000 ÷ 1.25 = $206,400; $206,400 – ($180,000 ÷ 1.20) = $56,400;
$120,000 + [($180,000 ÷ 1.20) – $120,000) × 1.2] = $156,000
$156,000 + ($56,400 × 1.25) = $226,500.
131. Opera Corp. uses the dollar-value LIFO method of computing its inventory cost. Data for the past four
years is as follows:
Year ended Inventory at Price
December 31. End-of-year Prices Index

2011 $130,000 1.00
2012 252,000 1.05
2013 270,000 1.10
What is the 2011 inventory balance using dollar-value LIFO?
a. $130,000.
202
b. $123,808.
c. $245,454.
d. $270,000.
$130,000 × 1.00 = $130,000.
132. Opera Corp. uses dollar-value LIFO method of computing its inventory cost. Data for the past four years
is as follows:

2011 $ 130,000 1.00 2012 252,000 1.05
2013 270,000 1.10
a. $252,000.
b. $257,000.
c. $245,500.
d. $251,500.
$252,000 ÷ 1.05 = $240,000; $240,000 – $130,000 = $110,000.
$130,000 + ($110,000 × 1.05) = $245,500.
133. Opera Corp. uses dollar-value LIFO method of computing its inventory cost. Data for the past four years
is as follows:

2011 $ 130,000 1.00
2012 252,000 1.05
2013 270,000 1.10
a. $270,000.
b. $257,000.
c. $245,500.
d. $251,500.
$270,000 ÷ 1.10 = $245,455; $245,455 – ($252,000 ÷ 1.05) = $5,455;
$252,000 ÷ 1.05 = $240,000; $240,000 – $130,000 = $110,000;
$130,000 + ($110,000 × 1.05) + ($5,455 × 1.10) = $251,500.
134. How should the following costs affect a retailer's inventory valuation?
Freight-in Interest on Inventory Loan
a. Increase No effect
b. Increase Increase
c. No effect Increase
d. No effect No effect
135. The following information applied to Howe, Inc. for 2012:

Merchandise purchased for resale $350,000
Freight-in 8,000 Freight-out 5,000
Purchase returns 2,000
Howe's 2012 inventoriable cost was
a. $350,000.
b. $353,000.
c. $356,000.
d. $361,000.
$350,000 + $8,000 – $2,000 = $356,000.
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136. The following information was derived from the 2012 accounting records of Perez Co.:
Perez 's Goods
Perez 's Central Warehouse Held by Consignees Beginning inventory $130,000 $
14,000
Purchases 475,000 70,000 Freight-in 10,000
Transportation to consignees 5,000
Freight-out 30,000 8,000
Ending inventory 145,000 20,000
Perez's 2012 cost of sales was
a. $470,000.
b. $500,000.
c. $534,000.
d. $539,000.
$130,000 + $14,000 + $475,000 + $70,000 + $10,000 + $5,000 –
145,000 – $20,000 = $539,000.
137. Dole Corp.'s accounts payable at December 31, 2012, totaled $650,000 before any necessary year-
end adjustments relating to the following transactions:
• On December 27, 2012, Dole wrote and recorded checks to creditors totaling $350,000 causing an
overdraft of $100,000 in Dole's bank account at December 31, 2012. The checks were mailed out
on January 10, 2013.
• On December 28, 2012, Dole purchased and received goods for $150,000, terms 2/10, n/30. Dole
records purchases and accounts payable at net amounts. The invoice was recorded and paid
January 3, 2013.
• Goods shipped f.o.b. destination on December 20, 2012 from a vendor to Dole were received
January 2, 2013. The invoice cost was $65,000.
At December 31, 2012, what amount should Dole report as total accounts payable? a.
$1,212,000.
b. $1,147,000.
c. $900,000.
d. $800,000.
$650,000 + $350,000 + $147,000 = $1,147,000.
138. The balance in Moon Co.'s accounts payable account at December 31, 2012 was $900,000 before any
necessary year-end adjustments relating to the following:
• Goods were in transit to Moon from a vendor on December 31, 2012. The invoice cost was
$40,000. The goods were shipped f.o.b. shipping point on December 29, 2012 and were received
on January 4, 2013.
• Goods shipped f.o.b. destination on December 21, 2012 from a vendor to Moon were received on
January 6, 2013. The invoice cost was $25,000.
• On December 27, 2012, Moon wrote and recorded checks to creditors totaling $30,000 that were
mailed on January 10, 2013.
In Moon's December 31, 2012 balance sheet, the accounts payable should be a.
$930,000.
b. $940,000.
c. $965,000.
d. $970,000.
$900,000 + $40,000 + $30,000 = $970,000.
139. Kerr Co.'s accounts payable balance at December 31, 2012 was $1,300,000 before considering the
following transactions:
• Goods were in transit from a vendor to Kerr on December 31, 2012. The invoice price was $70,000,
and the goods were shipped f.o.b. shipping point on December 29, 2012. The goods were received
on January 4, 2013.
204
• Goods shipped to Kerr, f.o.b. shipping point on December 20, 2012, from a vendor were lost in
transit. The invoice price was $50,000. On January 5, 2013, Kerr filed a $50,000 claim against the
common carrier.
In its December 31, 2012 balance sheet, Kerr should report accounts payable of a. $1,420,000.
b. $1,370,000.
c. $1,350,000.
d. $1,300,000.
$1,300,000 + $70,000 + $50,000 = $1,420,000.
140. Walsh Retailers purchased merchandise with a list price of $75,000, subject to trade discounts of 20%
and 10%, with no cash discounts allowable. Walsh should record the cost of this merchandise as a.
$52,500.
b. $54,000.
c. $58,500.
d. $75,000.
$75,000 × .8 × .9 = $54,000.
141. On June 1, 2012, Penny Corp. sold merchandise with a list price of $40,000 to Linn on account. Penny
allowed trade discounts of 30% and 20%. Credit terms were 2/15, n/40 and the sale was made f.o.b.
shipping point. Penny prepaid $800 of delivery costs for Ison as an accommodation. On June 12,
2012, Penny received from Linn a remittance in full payment amounting to a. $21,952.
b. $22,736.
c. $22,752.
d. $22,392.
$40,000 × .7 × .8 = $22,400
($22,400 × .98) + 800 = $22,752.
142. Groh Co. recorded the following data pertaining to raw material X during January 2012:
Units
Date Received Cost Issued On Hand
1/1/12 Inventory $4.00 3,200 1/11/12 Issue 1,600 1,600
1/22/12 Purchase 4,000 $4.70 5,600
The moving-average unit cost of X inventory at January 31, 2012 is a. $4.35.
b. $4.42.
c. $4.50.
d. $4.70.
[(1,600 × $4.00) + (4,000 × $4.70)] ÷ 5,600 = $4.50.
143. During periods of rising prices, a perpetual inventory system would result in the same dollar amount of
ending inventory as a periodic inventory system under which of the following inventory cost flow
methods?
FIFO LIFO
a. Yes No
b. Yes Yes
c. No Yes
d. No No
144. Hite Co. was formed on January 2, 2012, to sell a single product. Over a two-year period, Hite's
acquisition costs have increased steadily. Physical quantities held in inventory were equal to three
months' sales at December 31, 2012, and zero at December 31, 2013. Assuming the periodic
inventory system, the inventory cost method which reports the highest amount of each of the following
is
Inventory Cost of Sales December 31, 2012
2013
a. LIFO FIFO
b. LIFO LIFO
c. FIFO FIFO
d. FIFO LIFO
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145. Keck Co. had 450 units of product A on hand at January 1, 2012, costing $21 each. Purchases of
product A during January were as follows:
Date Units Unit Cost
Jan. 10 600 $22
18 750 23
28 300 24
A physical count on January 31, 2012 shows 600 units of product A on hand. The cost of the inventory at
January 31, 2012 under the LIFO method is a. $14,100.
b. $13,350.
c. $12,750.
d. $12,300.
(450 × $21) + (150 × $22) = $12,750.
146. When the double extension approach to the dollar-value LIFO inventory cost flow method is used, the
inventory layer added in the current year is multiplied by an index number. How would the following be
used in the calculation of this index number?
Ending inventory Ending inventory at
current year cost at
base year cost
a. Numerator Denominator
b. Numerator Not used
c. Denominator Numerator
d. Not used Denominator
147. Farr Co. adopted the dollar-value LIFO inventory method on December 31, 2012. Farr's entire inventory
constitutes a single pool. On December 31, 2012, the inventory was $480,000 under the dollar-value
LIFO method. Inventory data for 2013 are as follows:
12/31/13 inventory at year-end prices $660,000 Relevant price index
at year end (base year 2012) 110
Using dollar value LIFO, Farr's inventory at December 31, 2013 is
a. $528,000.
b. $612,000.
c. $600,000.
d. $660,000.
$660,000 ÷ 1.1 = $600,000
$480,000 + ($120,000 × 1.1) = $612,000.
68. Oslo Corporation has two products in its ending inventory, each accounted for at the lower of cost or
market. A profit margin of 30% on selling price is considered normal for each product. Specific data
with respect to each product follows:
Product #1 Product #2
Historical cost $20.00 $ 35.00 Replacement cost 22.50 27.00
Estimated cost to dispose 5.00 13.00
Estimated selling price 40.00 65.00
In pricing its ending inventory using the lower-of-cost-or-market, what unit values should Oslo use for
products #1 and #2, respectively?
a. $20.00 and $32.50.
b. $23.00 and $32.50.
c. $23.00 and $30.00.
d. $22.50 and $27.00.
a Product 1: RC = $22.50, NRV = $40 – $5 = $35
NRV – PM = $35 – ($40 × .3) = $23, cost = $20. Product 2: RC = $27, NRV = $65 – $13 = $52
NRV – PM = $52 – ($65 × .3) = $32.50, cost = $35.
206
69. Muckenthaler Company sells product 2005WSC for $30 per unit. The cost of one unit of 2005WSC is
$27, and the replacement cost is $26. The estimated cost to dispose of a unit is $6, and the normal
profit is 40%. At what amount per unit should product 2005WSC be reported, applying lower-of-cost-
or-market?
a. $12.
b. $24.
c. $26.
d. $27.
b NRV = $30 – $6 = $24, RC = $26

NRV – PM = $24 – ($30 × .40) = $12, cost = $27.
70. Lexington Company sells product 1976NLC for $50 per unit. The cost of one unit of 1976NLC is $45,
and the replacement cost is $43. The estimated cost to dispose of a unit is $10, and the normal profit
is 40%. At what amount per unit should product 1976NLC be reported, applying lower-of-cost-or-
market?
a. $20.
b. $40.
c. $43.
d. $45.
NRV = $50 – $10 = $40, RC = $43

NRV – PM = $40 – ($50 × .40) = $20, cost = $45.
71. Given the acquisition cost of product Z is $64, the net realizable value for product Z is $58, the normal
profit for product Z is $5, and the market value (replacement cost) for product Z is $60, what is the
proper per unit inventory price for product Z?
a. $64.
b. $60.
c. $53.
d. $58.
$58 MV, $64 Cost, LCM = $58.
72. Given the acquisition cost of product ALPHA is $17, the net realizable value for product
ALPHA is $16.70, the normal profit for product ALPHA is $1.24, and the market value (replacement
cost) for product ALPHA is $14.72, what is the proper per unit inventory price for product ALPHA?
a. $17.00.
b. $15.46
c. $14.72.
d. $16.70.
$15.46 ($16.70 – $1.24) MV, $17.00 Cost, LCM = $15.46.
73. Given the acquisition cost of product Dominoe is $43.31, the net realizable value for product Dominoe
is $38.49, the normal profit for product Dominoe is $4.32, and the market value (replacement cost) for
product Dominoe is $40.68, what is the proper per unit inventory price for product Dominoe?
a. $40.68.
b. $34.18.
c. $38.49.
d. $43.31
$38.49 MV, $43.31 Cost, LCM = $38.49.
207
74. Given the historical cost of product Z is $80, the selling price of product Z is $95, costs to sell product
Z are $11, the replacement cost for product Z is $83, and the normal profit margin is 40% of sales
price, what is the market value that should be used in the lower-ofcost-or-market comparison?
a. $80.
b. $84.
c. $83.
d. $46.
Ceiling $84 ($95 – $11); Floor $46 ($84 – $38), RC $83; $83 MV.
75. Given the historical cost of product Z is $80, the selling price of product Z is $95, costs to sell product
Z are $11, the replacement cost for product Z is $83, and the normal profit margin is 40% of sales
price, what is the amount that should be used to value the inventory under the lower-of-cost-or-market
method?
a. $46.
b. $80.
c. $84.
d. $83.
Ceiling $84 ($95 – $11), Floor $46 ($84 – $38), RC $83; $83 MV, $80 Cost, LCM = $80.
76. Given the historical cost of product Dominoe is $43, the selling price of product Dominoe is $60, costs
to sell product Dominoe are $11, the replacement cost for product Dominoe is $40, and the normal
profit margin is 20% of sales price, what is the cost amount that should be used in the lower-of-cost-
or-market comparison?
a. $49.
b. $40.
c. $37.
d. $43.
$43 Cost.
77. Given the historical cost of product Dominoe is $43, the selling price of product Dominoe is $60, costs
to sell product Dominoe are $11, the replacement cost for product Dominoe is $40, and the normal
profit margin is 20% of sales price, what is the amount that should be used to value the inventory
under the lower-of-cost-or-market method?
a. $43.
b. $37.
c. $40.
d. $49.
Ceiling $49 ($60 – $11), Floor $37 ($49 – $12), RC $40; $40 MV, $43 Cost, LCM = $40.
78. Robust Inc. has the following information related to an item in its ending inventory. Product 66 has a
cost of $3,250, a replacement cost of $3,100, a net realizable value of $3,200, and a normal profit
margin of $200. What is the final lower-of-cost-or-market inventory value for product 66?
a. $3,200.
b. $3,100.
c. $3,250.
d. $3,100.
$3,100 MV, $3,250 Cost, LCM = $3,100.
79. Robust Inc. has the following information related to an item in its ending inventory. Packit
(Product # 874) has a cost of $524, a replacement cost of $402, a net realizable value of $468, and a
normal profit margin of $21. What is the final lower-of-cost-or-market inventory value for Packit?
208
a. $447.
b. $524.
c. $402.
d. $468.
$447 ($468 – $21) MV, $524 Cost, LCM = $447.
80. Robust Inc. has the following information related to an item in its ending inventory. Acer Top has a
cost of $251, a replacement cost of $234, a net realizable value of $266, and a normal profit margin of
$34. What is the final lower-of-cost-or-market inventory value for Acer Top?
a. $232.
b. $251.
c. $234.
d. $266.
$234 MV, $251 Cost, LCM = $234.
81. Mortenson Corporation sells its product, a rare metal, in a controlled market with a quoted price
applicable to all quantities. The total cost of 5,000 pounds of the metal now held in inventory is
$150,000. The total selling price is $360,000, and estimated costs of disposal are $10,000. At what
amount should the inventory of 5,000 pounds be reported in the balance sheet?
a. $140,000.
b. $150,000.
c. $350,000.
d. $360,000.
$360,000 – $10,000 = $350,000.
82. Rodriguez Corporation sells its product, a rare metal, in a controlled market with a quoted price
applicable to all quantities. The total cost of 5,000 pounds of the metal now held in inventory is
$210,000. The total selling price is $490,000, and estimated costs of disposal are $5,000. At what
amount should the inventory of 5,000 pounds be reported in the balance sheet?
a. $205,000.
b. $210,000.
c. $485,000.
d. $490,000.
$490,000 – $5,000 = $485,000.
83. Turner Corporation acquired two inventory items at a lump-sum cost of $80,000. The acquisition
included 3,000 units of product LF, and 7,000 units of product 1B. LF normally sells for $24 per unit,
and 1B for $8 per unit. If Turner sells 1,000 units of LF, what amount of gross profit should it
recognize?
a. $3,000
b. $9,000.
c. $16,000.
d. $19,000.
LF 3,000 × $24 = ($72,000 ÷ $128,000) × $80,000 = $45,000 1B 7,000 × $8 = $56,000; $56,000 +

$72,000 = $128,000 (1,000 × $24) – ($45,000 × 1,000/3,000) = $9,000.
84. Robertson Corporation acquired two inventory items at a lump-sum cost of $60,000. The acquisition
included 3,000 units of product CF, and 7,000 units of product 3B. CF normally sells for $18 per unit,
and 3B for $6 per unit. If Robertson sells 1,000 units of CF, what amount of gross profit should it
recognize?
a. $2,250.
209
b. $6,750.
c. $12,000.
d. $14,250.
CF 3,000 × $18 = ($54,000 ÷ $96,000) × $60,000 = $33,750 3B 7,000 × $6 = $42,000; $42,000 + $54,000 =
$96,000 (1,000 × $18) – ($33,750 × 1,000/3,000) = $6,750.
85. At a lump-sum cost of $72,000, Pratt Company recently purchased the following items for resale:
Item No. of Items Purchased Resale Price Per Unit
M 4,000 $3.75
N 2,000 12.00
O 6,000 6.00
The appropriate cost per unit of inventory is:
M N O
a. $3.75 $12.00 $6.00
b. $3.11 $19.86 $3.32
c. $3.60 $11.52 $5.76
d. $6.00 $6.00 $6.00
M 4,000 × $3.75 = $15,000 15 ÷ 75 × $72,000 = $14,400 ÷ 4,000 = $3.60

N 2,000 × $12.00= 24,000 24 ÷ 75 × $72,000 = $23,040 ÷ 2,000 = $11.52
O 6,000 × $6.00 = 36,000 36 ÷ 75 × $72,000 = $34,560 ÷ 6,000 = $5.76 $75,000
86. Confectioners, a chain of candy stores, purchases its candy in bulk from its suppliers. For a recent
shipment, the company paid $1,800 and received 8,500 pieces of candy that are allocated among
three groups. Group 1 consists of 2,500 pieces that are expected to sell for $0.15 each. Group 2
consists of 5,500 pieces that are expected to sell for $0.36 each. Group 3 consists of 500 pieces that
are expected to sell for $0.72 each. Using the relative sales value method, what is the cost per item in
Group 1?
a. $0.150.
b. $0.100.
c. $0.120.
d. $0.225.
(2,500 × $0.15) + (5,500 × $0.36) + (500 × $0.72) = $2,715; [(2,500 × $0.15) ÷ $2,715] × $1,800 =
$249 ÷ 2,500 = $0.100.
Group 2?
a. $0.225.
b. $0.360.
c. $0.210.
d. $0.239.
(2,500 × $0.15) + (5,500 × $0.36) + (500 × $0.72) = $2,715; [(5,500 × $0.36) ÷ $2,715] × $1,800 =
$1,313 ÷ 5,500 = $0.239.
210
Group 3?
a. $0.477.
b. $0.225.
c. $0.720.
d. $0.540.
(2,500 × $0.15) + (5,500 × $0.36) + (500 × $0.72) = $2,715; [(500 × $0.72) ÷ $2,715] × $1,800 = $239
÷ 500 = $0.477.
89. During the current fiscal year, Jeremiah Corp. signed a long-term noncancellable purchase
commitment with its primary supplier. Jeremiah agreed to purchase $2.5 million of raw materials
during the next fiscal year under this contract. At the end of the current fiscal year, the raw material to
be purchased under this contract had a market value of $2.3 million. What is the journal entry at the
end of the current fiscal year?
a. Debit Unrealized Holding Gain or Loss for $200,000 and credit Estimated Liability on
Purchase Commitment for $200,000.
b. Debit Estimated liability on Purchase Commitments for $200,000 and creditUnrealized Holding
Gain or Loss for $200,000.
c. Debit Unrealized Holding Gain or Loss for $2,300,000 and credit Estimated Liability on Purchase
Commitments for $2,300,000.
d. No journal entry is required.
$2.5 million – $2.3 million = $200,000. 90. c $2.5 million – $2.3 million = $200,000.
90. During the prior fiscal year, Jeremiah Corp. signed a long-term noncancellable purchase commitment
with its primary supplier to purchase $2.5 million of raw materials. Jeremiah paid the $2.5 million to
acquire the raw materials when the raw materials were only worth $2.3 million. Assume that the
purchase commitment was properly recorded. What is the journal entry to record the purchase?
a. Debit Inventory for $2,300,000, and credit Cash for $2,300,000.
b. Debit Inventory for $2,300,000, debit Unrealized Holding Gain or Loss for $200,000, and credit
Cash for $2,500,000.
c. Debit Inventory for $2,300,000, debit Estimated Liability on Purchase Commitments for
$200,000 and credit Cash for $2,500,000.
d. Debit Inventory for $2,500,000, and credit Cash for $2,500,000.
91. During 2012, Larue Co., a manufacturer of chocolate candies, contracted to purchase 200,000
pounds of cocoa beans at $4.00 per pound, delivery to be made in the spring of 2013. Because a
record harvest is predicted for 2013, the price per pound for cocoa beans had fallen to $3.30 by
December 31, 2012.
Of the following journal entries, the one which would properly reflect in 2012 the effect of the
commitment of Larue Co. to purchase the 100,000 pounds of cocoa is
a. Cocoa Inventory.............................................................. 400,000
Accounts Payable............................................... 400,000
b. Cocoa Inventory.............................................................. 330,000
Loss on Purchase Commitments.................................... 70,000
c. Unrealized Holding Gain or Loss-Income.......................
70,000
Estimated Liability on Purchase Commitments... 70,000
d. No entry would be necessary in 2012
($4.00 – $3.30) × 100,000 = $70,000.
211
92. RS Corporation, a manufacturer of ethnic foods, contracted in 2012 to purchase 500 pounds of a
spice mixture at $5.00 per pound, delivery to be made in spring of 2013. By 12/31/12, the price per
pound of the spice mixture had risen to $5.40 per pound. In 2012,
AJ should recognize
a. a loss of $2,500.
b. a loss of $200.
c. no gain or loss.
d. a gain of $200.
No gain or loss since 12/31 price ($5.40) > contract price ($5.00).
93. LF Corporation, a manufacturer of Mexican foods, contracted in 2012 to purchase 1,000 pounds of a
spice mixture at $5.00 per pound, delivery to be made in spring of 2013. By 12/31/12, the price per
pound of the spice mixture had dropped to $4.70 per pound. In
2012, LF should
recognize a a loss of
$5,000. b. a loss of
$300.
c. no gain or loss.
d. a gain of $300.
($5.00 – $4.70) × 1,000 = $300.
94. The following information is available for October for Barton Company.
Beginning inventory $150,000
Net purchases 450,000 Net sales 900,000
Percentage markup on cost 66.67%
A fire destroyed Barton’s October 31 inventory, leaving undamaged inventory with a cost of $9,000.
Using the gross profit method, the estimated ending inventory destroyed by fire is
a. $51,000.
b. $231,000.
c. $240,000.
d. $300,000.
($150,000 + $450,000) – ($900,000 ÷ 5/3) – $9,000 = $51,000.
95. The following information is available for October for Norton Company.
Net purchases 600,000 Net sales 1,200,000
Percentage markup on cost 66.67%
A fire destroyed Norton’s October 31 inventory, leaving undamaged inventory with a cost of $12,000.
Using the gross profit method, the estimated ending inventory destroyed by fire is
a. $68,000.
b. $308,000.
c. $320,000.
d. $400,000.
($200,000 + $600,000) – ($1,200,000 ÷ 5/3) – $12,000 = $68,000.

Miles Company, a wholesaler, budgeted the following sales for the indicated months:
June July August
Sales on account $2,700,000 $2,760,000 $2,850,000
Cash sales 270,000 300,000 390,000
212
Total sales $2,970,000 $3,060,000 $3,240,000
All merchandise is marked up to sell at its invoice cost plus 20%. Merchandise inventories at the beginning of
each month are at 30% of that month's projected cost of goods sold.
96. The cost of goods sold for the month of June is anticipated to be
a. $2,160,000.
b. $2,250,000.
c. $2,280,000.
d. $2,475,000.
(1 + .2)C = 2,970,000; C = $2,475,000.
97. Merchandise purchases for July are anticipated to be

a. $2,448,000.
b. $3,114,000.
c. $2,550,000.
d. $2,595,000.
COGS: July = $3,060,000 ÷ 1.2 = $2,550,000

Aug. = $3,240,000 ÷ 1.2 = $2,700,000
July's purchase = ($2,550,000 × .7) + ($2,700,000 × .3) = $2,595,000.
98. Reyes Company had a gross profit of $480,000, total purchases of $560,000, and an ending
inventory of $320,000 in its first year of operations as a retailer. Reyes’s sales in its first year must
have been
a. $720,000.
b. $880,000.
c. $240,000.
d. $800,000.
$480,000 + ($540,000 – $320,000) = $720,000.
99. A markup of 30% on cost is equivalent to what markup on selling price?

a. 23%
b. 30%
c. 70%
d. 77%
= .23 = 23%
100. Kesler, Inc. estimates the cost of its physical inventory at March 31 for use in an interim financial
statement. The rate of markup on cost is 25%. The following account balances are available:
Inventory, March 1 $385,000
Purchases 301,000
Purchase returns 14,000
Sales during March 525,000
The estimate of the cost of inventory at March 31 would be
a. $147,000.
b. $252,000.
c. $278,250.
d. $196,000.
213
COGS = $525,000 ÷ 1.25 = $420,000
($385,000 + $301,000 – $14,000) – $420,000 = $252,000.
101. On January 1, 2012, the merchandise inventory of Glaus, Inc. was $1,000,000. During 2012 Glaus
purchased $2,000,000 of merchandise and recorded sales of $2,500,000. The gross profit rate on
these sales was 25%. What is the merchandise inventory of Glaus at December 31, 2012?
a. $500,000.
b. $625,000.
c. $1,125,000.
d. $1,875,000.
COGS = $2,500,000 × .75 = $1,875,000
$1,000,000 + $2,000,000 – $1,875,000 = $1,125,000.
102. For 2012, cost of goods available for sale for Tate Corporation was $1,800,000. The gross profit rate
was 20%. Sales for the year were $1,600,000. What was the amount of the ending inventory?
a. $0.
b. $520,000.
c. $360,000.
d. $320,000.
$1,800,000 – ($1,600,000 × .80) = $520,000.
103. On April 15 of the current year, a fire destroyed the entire uninsured inventory of a retail store. The
following data are available:
Sales, January 1 through April 15 $360,000
Inventory, January 1 60,000
Purchases, January 1 through April 15 300,000
Markup on cost 25%
The amount of the inventory loss is estimated to be
a. $72,000.
b. $36,000.
c. $90,000.
d. $60,000.
$360,000
a $60,000 + $300,000 – ————— = $72,000.
1.25
104. The inventory account of Irick Company at December 31, 2012, included the following items:
Inventory Amount
Merchandise out on consignment at sales price
(including markup of 40% on selling price) $30,000
Goods purchased, in transit (shipped f.o.b. shipping point) 24,000
Goods held on consignment by Irick 26,000
Goods out on approval (sales price $15,200, cost $12,800) 15,200
Based on the above information, the inventory account at December 31, 2012, should be reduced by
a. $40,400.
b. $45,200.
c. $64,400.
d. $64,000.
($30,000 × 40%) + $26,000 + ($15,200 – $12,800) = $40,400.
214
105. The sales price for a product provides a gross profit of 20% of sales price. What is the gross profit as
a percentage of cost?
a. 20%.
b. 17%.
c. 25%.
d. Not enough information is provided to determine.
20% ÷ (100% – 20%) = 25%.
106. Gamma Ray Corp. has annual sales totaling $975,000 and an average gross profit of 20% of cost.
What is the dollar amount of the gross profit?
a. $195,000.
b. $146,250.
c. $162,500.
d. $243,750.
$975,000 – ($975,000 ÷ 1.20) = $162,500.
107. On August 31, a hurricane destroyed a retail location of Vinny's Clothier including the entire inventory
on hand at the location. The inventory on hand as of June 30 totaled $640,000. Since June 30 until
the time of the hurricane, the company made purchases of $170,000 and had sales of $500,000.
Assuming the rate of gross profit to selling price is 40%, what is the approximate value of the
inventory that was destroyed?
a. $640,000.
b. $363,000.
c. $410,000.
d. $510,000.
($640,000 + $170,000) – [$500,000 × (1 – .40)] = $510,000.
108. On October 31, a fire destroyed PH Inc.'s entire retail inventory. The inventory on hand as of January
1 totaled $1,360,000. From January 1 through the time of the fire, the company made purchases of
$330,000 and had sales of $720,000. Assuming the rate of gross profit to selling price is 40%, what is
the approximate value of the inventory that was destroyed?
a. $1,360,000.
b. $1,346,000.
c. $970,000.
d. $1,258,000.
($1,360,000 + $330,000) – [$720,000 × (1 – .40)] = $1,258,000.
109. On March 15, a fire destroyed Interlock Company's entire retail inventory. The inventory on hand as of
January 1 totaled $3,300,000. From January 1 through the time of the fire, the company made
purchases of $1,366,000, incurred freight-in of $156,000, and had sales of $2,420,000. Assuming the
rate of gross profit to selling price is 30%, what is the approximate value of the inventory that was
destroyed?
a. $4,096,000.
b. $2,972,000.
c. $3,128,000.
d. $4,822,000.
$3,300,000 + $1,366,000 + $156,000 – [$2,420,000 × (1 – .30)] = $3,128,000.
110. Dicer uses the conventional retail method to determine its ending inventory at cost.
215
Assume the beginning inventory at cost (retail) were $260,000 ($396,000), purchases during the
current year at cost (retail) were $1,370,000 ($2,200,000), freight-in on these purchases totaled
$86,000, sales during the current year totaled $2,100,000, and net markups (markdowns) were
$48,000 ($72,000). What is the ending inventory value at cost?
a. $306,328.
b. $312,330.
c. $314,824.
d. $472,000.
$396,000 + $2,200,000 + $48,000 – $2,100,000 – $72,000 = $472,000; ($260,000 + $1,370,000 +

$86,000) ÷ ($396,000 + $2,200,000 + $48,000) = .649; $472,000 × .649 = $306,328.
111. Boxer Inc. uses the conventional retail method to determine its ending inventory at cost.
$79,500, sales during the current year totaled $2,433,000, and net markups were $207,000. What
is the ending inventory value at cost?
a. $667,800.
b. $523,098.
c. $426,723.
d. $456,924.
$297,000 + $2,596,800 + $207,000 – $2,433,000 = $667,800;
($196,500 + $1,704,000 + $79,500) ÷ ($297,000 + $2,596,800 + $207,000) = 63.9%; $667,800
× .639 = $426,723.
112. Barker Pet supply uses the conventional retail method to determine its ending inventory at cost.
$127,800, sales during the current year totaled $2,604,000, and net markups (markdowns) were
$4,000 ($192,600). What is the ending inventory value at cost?
a. $633,400.
b. $516,222.
c. $822,000.
d. $493,334.
$653,800 + $1,386,100 + $4,000 – $2,604,000 – $192,600 = $633,400;

($531,200 + $2,137,200 + $127,800) ÷ ($653,800 + $2,772,200 + $4,000) = 81.5%; $633,400
× .815 = $516,222.
113. Crane Sales Company uses the retail inventory method to value its merchandise inventory. The
following information is available for the current year:
Cost Retail
Beginning inventory $ 30,000 $ 50,000
Purchases 175,000 240,000
Freight-in 2,500 — Net markups — 8,500 Net markdowns — 10,000
Employee discounts — 1,000
Sales — 205,000
If the ending inventory is to be valued at the lower-of-cost-or-market, what is the cost to retail ratio?
a. $207,500 ÷ $290,000
b. $207,500 ÷ $298,500
c. $205,000 ÷ $300,000
d. $207,500 ÷ $288,500
Cost: $30,000 + $175,000 + $2,500 = $207,500. Retail: $50,000 + $240,000 + $8,500 = $298,500.
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The following data concerning the retail inventory method are taken from the financial records of Welch
Company.
Cost Retail
Purchases 448,000 640,000
Freight-in 12,000 — Net markups — 40,000 Net markdowns
— 28,000
Sales — 672,000
114. The ending inventory at retail should be

a. $148,000.
b. $120,000.
c. $128,000.
d.$84,000.
$140,000 + $640,000 + $40,000 – $28,000 – $672,000 = $120,000.
115. If the ending inventory is to be valued at approximately the lower of cost or market, the calculation of
the cost to retail ratio should be based on goods available for sale at (1) cost and (2) retail,
respectively of
a. $558,000 and $820,000.
b. $558,000 and $792,000.
c. $558,000 and $780,000.
d. $546,000 and $780,000.
Cost: $98,000 + $448,000 + $12,000 = $558,000.

Retail: $140,000 + $640,000 + $40,000 = $820,000.
116. If the foregoing figures are verified and a count of the ending inventory reveals that merchandise
actually on hand amounts to $108,000 at retail, the business has
a. realized a windfall gain.
b. sustained a loss.
c. no gain or loss as there is close coincidence of the inventories.
d. none of these.
*117. Assuming no change in the price level if the LIFO inventory method were used in conjunction with the
data, the ending inventory at cost would be
a. $85,200.
b. $84,000.
c. $81,600.
d. $86,400.
$98,000
———— × $120,000 = $84,000.
$140,000
*118. Assuming that the LIFO inventory method were used in conjunction with the data and that the inventory
at retail had increased during the period, then the computation of retail in the cost to retail ratio would
a. exclude both markups and markdowns and include beginning inventory.
b. include markups and exclude both markdowns and beginning inventory.
c. include both markups and markdowns and exclude beginning inventory.
d. exclude markups and include both markdowns and beginning inventory.
217
119. Drake Corporation had the following amounts, all at retail:
Beginning inventory $ 3,600 Purchases $140,000
Purchase returns 6,000 Net markups 18,000
Abnormal shortage 4,000 Net markdowns 2,800
Sales 72,000 Sales returns 1,800 Employee discounts 1,600 Normal shortage 2,600
What is Drake’s ending inventory at retail?
a. $74,400.
b. $76,000.
c. $77,600.
d. $78,400
$3,600 + $134,000 + $18,000 – $4,000 – $70,200 – $1,600 – $2,800 – $2,600 = $74,400.
120. Goren Corporation had the following amounts, all at retail:
Beginning inventory $ 3,600 Purchases $110,00
Purchase returns 6,000 Net markups 18,00
Abnormal shortage 4,000 Net markdowns 2,80
Sales 72,000 Sales returns 1,800 Employee discounts 1,600 Normal shortage 2,600
What is Goren’s ending inventory at retail?
a. $44,400.
b. $46,000.
c. $47,600.
d. $48,400
$3,600 + $104,000 + $18,000 – $4,000 – $70,200 – $1,600 – $2,800 – $2,600 = $44,400.
121. Fry Corporation’s computation of cost of goods sold is:

Beginning inventory $ 60,000
Add: Cost of goods purchased 530,000 Cost of goods
available for sale 590,000
Cost of goods sold $500,000
The average days to sell inventory for Fry are a.
43.5 days.
b. 50.3 days.
c. 54.5 days.
d. 65.2 days.
$500,000 ÷ [($60,000 + $90,000) ÷ 2] = 6.7; 365 ÷ 6.7 = 54.5.
122. East Corporation’s computation of cost of goods sold is:

Add: Cost of goods purchased 482,000 Cost of goods
available for sale 542,000
The average days to sell inventory for East are
a. 68.3 days.
b. 75.7 days.
c. 55.3 days.
d. 90.9 days.
2 $462,000 ÷ [($60,000 + $80,000) ÷ 2] = 6.6; 365 ÷ 6.6 = 55.3.

218
123. The 2012 financial statements of Sito Company reported a beginning inventory of $80,000, an ending
inventory of $120,000, and cost of goods sold of $800,000 for the year. Sito’s inventory turnover ratio
for 2012 is
a. 10.0 times.
b. 8.0 times.
c. 6.7 times.
d. 5.7 times.
$800,000 ÷ [($80,000 + $120,000) ÷ 2] = 8 times
124. Boxer Inc. reported inventory at the beginning of the current year of $360,000 and at the end of the
current year of $411,000. If net sales for the current year are $3,321,900 and the corresponding cost
of sales totaled $2,819,100, what is the inventory turnover ratio for the current year?
a. 8.61.
b. 6.86.
c. 7.83.
d. 7.31.
$2,819,100 ÷ [($360,000 + $411,000) ÷ 2] = 7.31.
Plank Co. uses the retail inventory method. The following information is available for the current year.
Cost Retail
Beginning inventory $ 156,000 $244,000
Purchases 590,000 830,000
Freight-in 10,000 —
Employee discounts — 4,000 Net markups — 30,000 Net Markdowns —
40,000
Sales — 780,000
125. If the ending inventory is to be valued at approximately lower of average cost or market, the
calculation of the cost ratio should be based on cost and retail of
a. $600,000 and $860,000.
b. $600,000 and $856,000.
c. $746,000 and $1,100,000.
d. $756,000 and $1,104,000.
Cost: $156,000 + $590,000 + $10,000 = $756,000.

Retail: $244,000 + $830,000 + $30,000 = $1,104,000.
126. The ending inventory at retail should be

a. $320,000.
b. $300,000.
c. $288,000.
d. $280,000.
2 $244,000 + $830,000 – $4,000 + $30,000 – $40,000 – $780,000 = $280,000.
127. The approximate cost of the ending inventory by the conventional retail method is
a. $191,800.
b. $189,840.
c. $196,000.
d. $204,960.
219
$280,000 × .685 = $191,800.
*128. If the ending inventory is to be valued at approximately LIFO cost, the calculation of the cost ratio should
be based on cost and retail of
a. $756,000 and $1,104,000.
b. $756,000 and $1,064,000.
c. $600,000 and $820,000.
d. $600,000 and $860,000.
Cost: $590,000 + $10,000 = $600,000.
Retail: $830,000 + $30,000 – $40,000 = $820,000.
*129. Assuming that the LIFO inventory method is used, that the beginning inventory is the base inventory
when the index was 100, and that the index at year end is 112, the ending inventory at dollar-value
LIFO retail cost is
a. $160,920.
b. $185,514.
c. $191,800.
d. $204,960.
Base year price = EI = = $250,000

$244,000 @ cost = $156,000
$6,000 × .732* × 1.12 = 4,920
$160,920
$600,000
* ————— = .732
$820,000
Eaton Company, which uses the retail LIFO method to determine inventory cost, has provided the following
information for 2012:
Cost Retail
Inventory, 1/1/12 $ 141,000 $210,000 Net purchases 567,000 843,000
Net markups 102,000 Net markdowns 45,000
Net sales 795,000
*130. Assuming stable prices (no change in the price index during 2012), what is the cost of Eaton's inventory
at December 31, 2012?
a. $192,150.
b. $207,150.
c. $204,000.
d. $198,450.
Cost to retail ratio = $567,000 ÷ ($843,000 + $102,000 – $45,000) = 0.63

EI=$210,000 + $843,000 + $102,000 – $45,000 – $795,000 = $315,000 at retail
$315,000 – $210,000 = $105,000
Cost of inventory = $141,000 + ($105,000 × .63) = $207,150.
*131. Assuming that the price index was 105 at December 31, 2012 and 100 at January 1, 2012, what is the
cost of Eaton's inventory at December 31, 2012 under the dollar-value-LIFO retail method?
a. $200,535.
b. $208,372.
c. $210,458.
d. $197,700.
220
Base year price: EI = $315,000 ÷ 1.05 = $300,000
$210,000 @ cost = $ 141,000
90,000 × .63 × 1.05 = 59,535
$300,000 $200,535
MULTIPLE CHOICE—CPA Adapted
132. Ryan Distribution Co. has determined its December 31, 2012 inventory on a FIFO basis at $500,000.
Information pertaining to that inventory follows:
Estimated selling price $510,000
Estimated cost of disposal 20,000 Normal profit margin
60,000
Current replacement cost 450,000
Ryan records losses that result from applying the lower-of-cost-or-market rule. At December 31,
2012, the loss that Ryan should recognize is
a. $0.
b. $10,000.
c. $40,000.
d. $50,000.
$500,000 – $450,000 (RC) = $50,000.
133. Under the lower-of-cost-or-market method, the replacement cost of an inventory item would be used
as the designated market value
a. when it is below the net realizable value less the normal profit margin.
b. when it is below the net realizable value and above the net realizable value less the normal
profit margin.
c. when it is above the net realizable value.
d. regardless of net realizable value.
134. The original cost of an inventory item is above the replacement cost and the net realizable value. The
replacement cost is below the net realizable value less the normal profit margin. As a result, under the
lower-of-cost-or-market method, the inventory item should be reported at the
a. net realizable value.
b. net realizable value less the normal profit margin.
c. replacement cost.
d. original cost.
135. Keen Company's accounting records indicated the following information:

Inventory, 1/1/12 $ 900,000 Purchases during 2012 4,500,000
Sales during 2012 5,700,000
A physical inventory taken on December 31, 2012, resulted in an ending inventory of $1,050,000.
Keen's gross profit on sales has remained constant at 25% in recent years. Keen suspects some
inventory may have been taken by a new employee. At December 31, 2012, what is the estimated
cost of missing inventory?
a. $75,000.
b. $225,000.
c. $300,000.
d. $375,000.
$5,700,000 × .75 = $4,275,000 (COGS)
$900,000 + $4,500,000 – $4,275,000 – $1,050,000 = $75,000.
221
136. Henke Co. uses the retail inventory method to estimate its inventory for interim statement purposes.
Data relating to the computation of the inventory at July 31, 2012, are as follows:
Cost Retail
Inventory, 2/1/12 $ 200,000 $ 250,000 Purchases 1,000,000 1,575,000
Markups, net 175,000
Sales 1,650,000
Estimated normal shoplifting losses 20,000
Markdowns, net 110,000
Under the lower-of-cost-or-market method, Henke's estimated inventory at July 31, 2012 is
a. $132,000.
b. $144,000.
c. $156,000.
d. $220,000.
($200,000 + $1,000,000) ÷ ($250,000 + $1,575,000 + $175,000) = 0.6 ($250,000 + $1,575,000 + $175,000 –

$20,000 – $110,000 – $1,650,000) × 0.6 = $132,000.
137. At December 31, 2012, the following information was available from Kohl Co.'s accounting records:
Cost Retail
Inventory, 1/1/12 $147,000 $ 203,000
Purchases 833,000 1,155,000 Additional markups 42,000
Available for sale $980,000 $1,400,000
Sales for the year totaled $1,150,000. Markdowns amounted to $10,000. Under the lowerof-cost-or-
market method, Kohl's inventory at December 31, 2012 was
a. $294,000.
b. $175,000.
c. $182,000.
d. $168,000.
$980,000 ÷ $1,400,000 = 0.7

($1,400,000 – $10,000 – $1,150,000) × 0.7 = $168,000.
*138. On December 31, 2012, Pacer Co. adopted the dollar-value LIFO retail inventory method.
Inventory data for 2013 are as follows:
LIFO Cost Retail
Inventory, 12/31/12 $450,000 $630,000
Inventory, 12/31/13 ? 825,000 Increase in price level for 2013 10%
Cost to retail ratio for 2013 70%
Under the LIFO retail method, Pacer's inventory at December 31, 2013, should be
a. $542,400.
b. $577,500.
c. $586,500.
d. d $600,150.
$825,000 ÷ 1.1 = $750,000

$450,000 + ($120,000 × 1.1 × .7) = $542,400.
EXERCISES
Ex. 8-148—Recording purchases at net amounts.
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Flint Co. records purchase discounts lost and uses perpetual inventories. Prepare journal entries in general
journal form for the following:
(a) Purchased merchandise costing $1,500 with terms 2/10, n/30.
(b) Payment was made thirty days after the purchase.
Solution 8-148
(a) Inventory (.98 × $900)................................................................ 1,470
Accounts Payable........................................................... 1,470
(b) Accounts Payable ...................................................................... 1,470 Purchase Discounts
Lost ........................................................... 30
Cash............................................................................... 1,500
Ex. 8-149—Recording purchases at net amounts.

Dill Co. records purchases at net amounts and uses periodic inventories. Prepare entries for the following:
June 11 Purchased merchandise on account, $8,000, terms 2/10, n/30.
15 Returned part of June 11 purchase, $500, and received credit on account. 30
Prepared the adjusting entry required for financial statements.
Solution 8-149
June 11 Purchases (.98 × $8,000)............................................... 7,840
40
15 Accounts Payable (.98 × $500)...................................... 490
Purchase Returns and Allowances..................... 4
9
0
30 Purchase Discounts Lost (.02 × $7,500)........................ 150
Accounts Payable............................................... 1
5
0
Ex. 8-150—Comparison of FIFO and LIFO.

During periods of rising prices, the use of FIFO (as compared with LIFO) will result in what effect on the
financial statements?
Solution 8-150
During periods of rising prices, the use of FIFO will result in higher inventory, lower cost of goods sold, and
higher gross profit, net income, income taxes, and retained earnings.
Ex. 8-151—FIFO and LIFO inventory methods.

During June, the following changes in inventory item 27 took place:
June 1 Balance 1,400 units @

$24
14 Purchased 800 units @
$36
24 Purchased 700 units @
$30
8 Sold 400 units @
$50
10 Sold 1,000 units @
223
$40
29 Sold 600 units @
$44
Perpetual inventories are maintained.
Instructions
What is the cost of the ending inventory for item 27 under the following methods? (Show calculations.) (a)
FIFO.
(b) LIFO.
Solution 8-151
(a) 700 @ $30 = $21,0
00
200 @ $36 =
7,20
0
$28,2
00
(b) 800 @ $36 = $28,8
00
100 @ $30 =
3,000
$31,8
00
Ex. 8-152—FIFO and LIFO periodic inventory methods.

The Rock Shop shows the following data related to an item of inventory:
Inventory, January 1 100 units @
$5.00
Purchase, January 9 300 units @
$5.40
Purchase, January 19 70 units @
$6.00
Inventory, January 31 100 units
Instructions
(a) What value should be assigned to the ending inventory using FIFO?
(b) What value should be assigned to cost of goods sold using LIFO?
Solution 8-152
(a) 70 @ $6.00 = $420 30 @ $5.40 =
162
$582
(b) 70 @ $6.00 = $ 420 300 @ $5.40 =

1,620
$2,040
Ex. 8-153—Perpetual LIFO.

A record of transactions for the month of May was as follows:
PURCHASES SALES
May 1 (balance) 400 @ $4.20 May 3 200 @ $7.00
4 1,300 @ $4.10 6 1,000 @ 7.00 8 800 @ $4.30 12
900 @ 7.50 14 700 @ $4.40 18 400 @ 7.50
224
22 1,200 @ $4.50 25 1,400 @ 8.00
29 300 @ $4.55
Assuming that perpetual inventory records are kept in dollars, determine the inventory using LIFO.
Solution 8-153
200 @ $4.20 = $ 840 200 @ $4.10 =
820
100 @ $4.40 = 440 300 @ $4.55
= 1,365
$3,465
Ex. 8-154—Perpetual LIFO and Periodic FIFO.

Matlock Corporation sells item A as part of its product line. Information as to balances on hand, purchases,
and sales of item A are given in the following table for the first six months of 2012.
Quantities
Unit
Price
Date Purchased Sold Balance of
Purchase
January 11 — — 400 $3.75
January 24 1,300 — 1,700 $3.90
February 8 — 300 1,400 —
March 16 — 560 840 —
June 11 600 — 1,440 $4.10
Instructions
(a) Compute the ending inventory at June 30 under the perpetual LIFO inventory pricing method.
(b)Compute the cost of goods sold for the first six months under the periodic FIFO inventory pricing
method.
Solution 8-154
(a) 400 @ $3.75 = $1,5
00
440 @ $3.90 = 1,7
16
600 @ $4.10 =
2,46
0
1,440 $5,6
76
(b) 400 @ $3.75 = $1,5
00
460 @ $3.90 =
1,79
4
860 $3,2
94
Ex. 8-155—Analysis of gross profit.
225
During 2012, King’s Drug Company experienced a significant increase in the rate of gross profit on sales,
compared with the rate it has averaged in recent years. You are asked to determine the most likely reason for
this improvement. Support your answer.
The following data are from the records of the company:

2012 sales (at an average price of $40 a unit) were $2,250,000.
2012 purchases (at an average cost of $24 a unit) were $1,200,000.
The company uses the LIFO inventory method and has used it since 1985.
Solution 8-155
6,250 more units were sold than were purchased. This has resulted in the partial liquidation of the beginning
LIFO inventory layers. Assuming rising prices, the increased rate of gross profit is most likely due to the
matching of old, lower inventory costs against current sales.
Computations
Units sold: $2,250,000 ÷ $40 = 56,250
Units purchased: $1,200,000 ÷ $24 = 50,000
Ex. 8-156—Dollar-value LIFO method.
Part A. Judd Company has a beginning inventory in year one of $500,000 and an ending inventory of
$605,000. The price level has increased from 100 at the beginning of the year to 110 at the end of
year one. Calculate the ending inventory under the dollarvalue LIFO method.
Part B. At the end of year two, Judd's inventory is $713,000 in terms of a price level of 115 which exists at the
end of year two. Calculate the inventory at the end of year two continuing the use of the dollar-
value LIFO method.
Solution 8-156
Part A.
Computation of Ending Inventory, Year One
Ending Inventory Layers at Ending Inventory
at Base-Year Price Base-Year Prices Price Index at Dollar-Value
LIFO
$605,000 ÷ 1.10 = $550,000 $500,000 × 1.00 = $500,000
$50,000 × 1.10 = 55,000
$555,000
Part B.
Computation of Ending Inventory, Year Two
Ending Inventory Layers at Ending Inventory
at Base-Year Price Base-Year Prices Price Index at Dollar-Value
LIFO
$713,000 ÷ 1.15 = $620,000 $500,000 × 1.00 = $500,000
$50,000 × 1.10 = 55,000
$70,000 × 1.15 = 80,500
$635,500
PROBLEMS
Pr. 8-157—Inventory cut-off.

Vogts Company sells TVs. The perpetual inventory was stated as $33,500 on the books at December 31,
2012. At the close of the year, a new approach for compiling inventory was used and apparently a satisfactory
cut-off for preparation of financial statements was not made. Some events that occurred are as follows.
226
1. TVs shipped to a customer January 2, 2013, costing $5,000 were included in inventory at December 31,
2012. The sale was recorded in 2013.
2. TVs costing $12,000 received December 30, 2012, were recorded as received on January 2, 2013.
3. TVs received during 2012 costing $4,600 were recorded twice in the inventory account.
4. TVs shipped to a customer December 28, 2012, f.o.b. shipping point, which cost $8,000, were not received
by the customer until January, 2013. The TVs were included in the ending inventory.
5. TVs on hand that cost $6,100 were never recorded on the books.
Instructions
Compute the correct inventory at December 31, 2012.
Solution 8-157
Inventory per books $33,5
00
Add: Shipment received 12/30/12 $12,000
TVs on hand 6,100
18,100
51,60
0
Deduct: TVs recorded twice 4,600
TVs shipped 12/28/12 8,000
12,600
Correct inventory 12/31/12 $39,00
0
Pr. 8-158—Analysis of errors.

(All sales and purchases are on credit.)
Indicate in each of the spaces provided the effect of the described errors on the various elements of a
company's financial statements. Use the following codes: O = amount is overstated; U = amount is
understated; NE = no effect. Assume a periodic inventory system.
Accounts Accounts Cost of
Receivable Inventory Payable Sales Goods Sold

EXAMPLE: Excluded goods in rented
warehouse from inventory NE U NE NE O count.
____________________________________________________________________________
1. Goods in transit shipped "f.o.b. destination"

by supplier were recorded as a
purchase but were excluded from ending
inventory.
____________________________________________________________________________
2. Goods held on consignment were included in

inventory count and recorded as a purchase.
____________________________________________________________________________
227
3. Goods in transit shipped "f.o.b. shipping point"
were not recorded as a sale and were included
in ending inventory.
____________________________________________________________________________
4. Goods were shipped and appropriately

excluded from ending inventory but sale was
not recorded.
____________________________________________________________________________
Solution 8-158
1. NE NE O NE O
2. NE O O NE NE
3. U O NE U U
4. U NE NE U NE
Pr. 8-159—Accounting for purchase discounts.

Otto Corp. purchased merchandise during 2012 on credit for $400,000; terms 2/10, n/30. All of the gross
liability except $80,000 was paid within the discount period. The remainder was paid within the 30-day term. At
the end of the annual accounting period, December 31, 2012, 90% of the merchandise had been sold and
10% remained in inventory. The company uses a periodic system.
Instructions
(a) Assuming that the net method is used for recording purchases, prepare the entries for the purchase and
two subsequent payments.
(b) What dollar amounts should be reported for the final inventory and cost of goods sold under the (1) net
method; (2) gross method? Assume that there was no beginning inventory.
Solution 8-159
(a) Purchases ............................................................................................. 392,000
Accounts Payable...................................................................... 392,0
(To record the purchase at net amount: 00
.98 × $400,000 = $392,000.)
Accounts Payable.................................................................................. 313,600
Cash .......................................................................................... 313,6
(To record payment within the discount period: 00
$400,000 – $80,000 = $320,000; .98 × $320,000 = $313,600.)
Accounts Payable.................................................................................. 78,400
Purchase Discounts Lost....................................................................... 1,600
Cash .......................................................................................... 80,0
(To record the final payment.) 00
(b) (1) Net method:

Purchases: $392,000
Final inventory: 10% × $392,000 = 39,200
Cost of goods sold: 90% × $392,000 = $352,800
228
(The $1,600 discount lost is reported in the other expense section of the income statement.)
(2) Gross method:

Purchases: $400,000 Purchases: $400,000
Less purchase discounts: Less purchase discounts:
.02 × $320,000 = 6,400 .02 × $320,000 = 6,400
Goods available 393,600 OR Goods available 393,600
Final inventory: Final inventory:
10% × $393,600 = 39,360 10% × $400,000 = 40,000
Cost of goods sold: Cost of goods sold:
90% × $393,600 = $354,240 $393,600 – $40,000 = $353,600
(Assuming that the $6,400 discount is (Assuming that the $6,400 discount is used
prorated between the cost of goods sold, to reduce cost of goods sold. Final
inventory
90%, and the final inventory, 10%.) is carried at the gross amount.)
Pr. 8-160—Inventory methods.

Jones Company was formed on December 1, 2011. The following information is available from Jones's
inventory record for Product X.
Units Unit
Cost
January 1, 2012 (beginning inventory) 1,600 $18.00
Purchases:
January 5, 2012 2,600 $20.00
January 25, 2012 2,400 $21.00
February 16, 2012 1,000 $22.00
March 15, 2012 1,800 $23.00
A physical inventory on March 31, 2012, shows 2,200 units on hand.

Instructions
Prepare schedules to compute the ending inventory at March 31, 2012, under each of the following inventory
methods:
(a) FIFO.
(b) LIFO.
(c) Weighted-average.
Show supporting computations in good form.
Solution 8-160
(a) Jones Company
COMPUTATION OF INVENTORY FOR PRODUCT X
UNDER FIFO INVENTORY METHOD
March 31, 2012

Cost
March 15, 2012 1,800 $23.00 $41,40
0
February 16, 2012 400 22.00 8,800
March 31, 2012, inventory 2,200 $50,20
0
229
(b) Jones Company
UNDER LIFO INVENTORY METHOD
March 31, 2012

Cost
Beginning inventory 1,600 $18.00 $28,80
0
January 5, 2012 (portion) 600 20.00
12,000
March 31, 2012, inventory 2,200 $40,80
0

(c) Jones Company
UNDER WEIGHTED-AVERAGE INVENTORY METHOD
March 31, 2012
Cost
Beginning inventory 1,600 $18.00 $
28,800
January 5, 2012 2,600 20.00 52,000
January 25, 2012 2,400 21.00 50,400
February 16, 2012 1,000 22.00 22,000
March 15, 2012 1,800 23.00
41,400
9,400 $194,6
00
Weighted average cost ($194,600 ÷ 9,400) $20.70
March 31, 2012, inventory 2,200 $20.70 $45,5

40
Pr. 8-161—Dollar-value LIFO.

Aber Company manufactures one product. On December 31, 2011, Aber adopted the dollar-value LIFO
inventory method. The inventory on that date using the dollar-value LIFO inventory method was $270,000.
Inventory data are as follows:
Inventory at Price index
Year year-end prices (base year 2009)

2012 $378,000 1.05 2013 552,000 1.15
2014 575,000 1.25
Instructions
Compute the inventory at December 31, 2012, 2013, and 2014, using the dollar-value LIFO method for each
year.
230
Solution 8-161
Aber Company
Dollar-Value LIFO Computations
At December 31, 2012, 2013, and 2014
Ending Layers at
Inventory at Base-Year Ending
Inventory
Base-Year Price Prices Price Index Dollar-Value
LIFO
At 12/31, $378,000 ÷ 1.05 $270,000 × 1.00 = $270,000
2012: = $360,000 $90,000 × 1.05 = 94,500
$364,500
At 12/31, $552,000 ÷ 1.15 $270,000 × 1.00 = $270,000

2013: = $480,000 $90,000 × 1.05 = 94,500
$120,000 × 1.15 = 138,000
$502,500
At 12/31, $575,000 ÷ 1.25 $270,000 × 1.00 = $270,0
00
2014: = $460,000 $90,000 × 1.05 = 94,500
$100,000 × 1.15 =
115,00
0
$479,5
00
Pr. 8-162—Dollar-value LIFO.

Gott Company adopted the dollar-value LIFO inventory method on 12/31/11. On this date, its inventory
consisted of the following items.
Item Number of Units Cost Per Unit Total Cost
X 200 $2.00 $ 400 Y 600 4.50 2,700
$3,100
Additional information: December 31

2012 2013
1. Units of X in inventory 300 400
2. Cost of each X unit $3.00 $3.25
3. Units of Y in inventory 800 1,200 4. Cost of each Y unit
$5.50 $6.00
Instructions
(a) Compute the price index for 2012. Round to 2 decimal places.
(b) Calculate the 12/31/12 inventory. Label all numbers.
(c) Compute the price index for 2013. Round to 2 decimal places.
(d) Calculate the 12/31/13 inventory. Label all numbers.
Solution 8-162
(a) Ending Inventory Ending Inventory
In End of Year Dollars: In Base Dollars
231
X 300 × $3.00 = $ 900 X 300 × $2.00 = $
600
Y 800 × $5.50 = 4,400 Y 800 × $4.50 =
3,60
0
$5,300 $4,2
Index = $5,300 ÷ $4,200 = 1.262 or 1.26 00
(b) Base Layer $3,100 × 1.00 = $3,1

00
Incremental Layer 1,100 × 1.26 =
1,38
6
2012 Ending Inventory $4,200 $4,4
86
(c) Ending Inventory Ending Inventory
In End of Year Dollars: In Base Dollars
X 400 × $3.25 = $1,300 X 400 × $2.00 = $
800
Y 1,200 × $6.00 = 7,200 Y 1,200 × $4.50 =
5,40
0
$8,500 $6,2
00
Index = $8,500 ÷ $6,200 = 1.371 or 1.37
(d) Base Layer $3,100 × 1.00 = $3,1
00
Incremental Layer 1,100 × 1.26 = 1,3
86
2,000 × 1.37 =
2,74
0
2013 Ending Inventory $6,200 $7,2
26
BE 150
Michelle Lee Company identifies the following items for possible inclusion in the physical inventory. Indicate
whether each item should be included or excluded from the inventory taking.
1. Goods shipped on consignment by Michelle Lee to another company.
2. Goods in transit from a supplier shipped FOB destination.
3. Goods shipped via common carrier to a customer with terms FOB shipping point.
4. Goods held on consignment from another company.
Solution 150 (3 min.)

1. Included
2. Excluded
3. Excluded
4. Excluded
BE 151
In the first month of operations, Barton Company made three purchases of merchandise in the following
sequence: (1) 200 units at $6, (2) 300 units at $7, and (3) 400 units at $8. Assuming there are 300 units on
hand, compute the cost of the ending inventory under (1) the FIFO method and (2) the LIFO method. Barton
uses a periodic inventory system.
232
1. FIFO
300 × $8 = $2,400
2. LIFO
200 × $6 = $1,200 100 × $7
= 700
$1,900
BE 152
Pembrook Company had beginning inventory on May 1 of $12,000. During the month, the company made
purchases of $30,000 but returned $2,000 of goods because they were defective. At the end of the month, the
inventory on hand was valued at $9,500.
Calculate cost of goods available for sale and cost of goods sold for the month.
00
Net purchases ($30,000 – $2,000) +28,0
00
Goods available for sale $40,0
00
Ending inventory –
9,500
00
BE 153
Opti Company's inventory records show the following data for the month of September:
Units Unit
Cost
Inventory, September 1 100 $3.00
Purchases: September 8 450 3.50
September 18 300 3.70
A physical inventory on September 30 shows 200 units on hand. Calculate the value of ending inventory and
cost of goods sold if the company uses FIFO inventory costing and a periodic inventory system.
Ending inventory of 200 units: 200 x $3.70 = $740
Cost of goods sold:
Units available for sale (100 + 450 + 300) = 850 Units sold 850 –
200 = 650
100 × $3 = $ 300 450 × $3.50
= 1,575 100 × $3.70 = 370
BE 154
Use the information in BE 153 to calculate the value of ending inventory and cost of goods sold if the company
uses LIFO inventory costing and a periodic inventory system.
Ending inventory: (100 units × $3.00) + (100 units × $3.50) = $650
Cost of goods sold: (300 units × $3.70) + (350 units × $3.50) = $2,335
BE 155
Use the information in BE 153 to calculate the value of the ending inventory and cost of goods sold if the
company uses weighted average inventory costing and a periodic inventory system. Round cost per unit to 2
decimal places and ending inventory and cost of goods sold to the nearest dollar.
233
Weighted average cost per unit:
Cost of goods available for sale = $2,985
Units available for sale 850
$2,985 ÷ 850 = $3.51
Ending inventory: 200 × $3.51 = $702
Cost of goods sold: 650 × $3.51 = $2,282
BE 156
The following accounts are included in the ledger of Able Company:
Advertising expense
Freight-in
Inventory
Purchases
Purchase returns and allowances
Sales
Sales returns and allowances
Which of the accounts would be included in calculating cost of goods sold?
Freight-in
Inventory
Purchases
Purchase returns and allowances
BE 157
The Entertainment Center accumulates the following cost and market data at December 31.
Inventory Categories Cost Data Market Data
Camera $11,000 $10,200 Camcorders 8,000 8,500
DVDs 14,000 12,000
What is the lower-of-cost-or-market value of the inventory?
Lower-of-
cost-
Inventory Categories Cost Data Market Data or-market
value
Camera $11,000 $10,200 $10,200
Camcorders 8,000 8,500 8,000
DVDs 14,000 12,000 12,000
$30,200
BE 158
Shelby Supply Company reports net income of $120,000 in 2008. The ending inventory did not include goods
valued at $5,000 that Shelby had consigned to Felicia’s Gift Shop.
(1) What is the correct net income for 2008?
(2)What impact will this error have on the balance sheet at 12/31/08?
(1) If ending inventory is understated by $5,000, cost of goods sold will be overstated and net income will be
understated by $5,000. The correct net income is $125,000.
(2)On the balance sheet, both inventory and owner’s equity will be understated by $5,000.
BE 159
At December 31, 2008, the following information was available for Rich Company: ending inventory $22,600;
beginning inventory $21,400; cost of goods sold $171,000; and sales revenue $430,000.
234
Calculate the inventory turnover ratio and days in inventory for Rich.

Inventory Turnover Ratio = $171,000 ÷ [($21,400 + $22,600) ÷ 2] = 7.8 times
Days in Inventory = 365 ÷ 7.8 = 46.8 days

Ex. 160
The following information is available for Harold Company:
Beginning inventory 600 units at $5 First purchase
900 units at $6
Second purchase 500 units at $7
Assume that Harold uses a periodic inventory system and that there are 700 units left at the end of the month.
Instructions
Compute the cost of ending inventory under the (a) FIFO
method.
(b) LIFO method.

(a) FIFO Ending Inventory Cost:
500 × $7 = $3,500 200
× $6 = 1,200
$4,700
(b) LIFO Ending Inventory Cost:

600 × $5 = $3,000 100
× $6 = 600
$3,600
Ex. 161
Using the information in Ex. 160 above, compute each of the following under the average-cost method:
(a) Cost of ending inventory.
(b)Cost of goods sold.
Average cost/unit = $5.95 ($11,900 ÷ 2,000)
600 × $5 = $ 3,000
900 × $6 = 5,400
500 × $7 = 3,500
2,000 $11,900
(a) Cost of ending inventory = $4,165 (700 × $5.95)
(b)Cost of goods sold = $7,735 (1,300 × $5.95) or $11,900 – $4,165
235
Ex. 162
Morton Company uses the periodic inventory method and had the following inventory information available:
Cost
1/1 Beginning Inventory 100 $4 $ 400
1/20 Purchase 400 $5 2,000
7/25 Purchase 200 $7 1,400
10/2 Purchase 300 $8 2,400
0
1,000 $6,200
A physical count of inventory on December 31 revealed that there were 400 units on hand.
Ex. 162 (cont.)
Instructions
Answer the following independent questions and show computations supporting your answers.
1. Assume that the company uses the FIFO method. The value of the ending inventory at December 31 is
$__________.
2. Assume that the company uses the Average-Cost method. The value of the ending inventory on
December 31 is $__________.
3. Assume that the company uses the LIFO method. The value of the ending inventory on December 31
is $__________.
4. Determine the difference in the amount of income that the company would have reported if it had used
the FIFO method instead of the LIFO method. Would income have been greater or less?
1. FIFO: Ending inventory $3,100
300 units @ $8 = $2,400
100 units @ $7 = 700
400 units $3,100
2. Average Cost: Ending inventory $2,480

$6,200 ÷ 1,000 = $6.20 per unit × 400 units = $2,480
3. LIFO: Ending Inventory $1,900

100 units @ $4 = $ 400 300 units @ $5 =
1,500
400 units $1,900
4. FIFO: Cost of goods sold $3,100 LIFO: Cost of goods sold $4,300
100 units @ $4 = $ 400 300 units @ $8 = $2,400
400 units @ $5 = 2,000 200 units @ $7 = 1,400
100 units @ $7 = 700 100 units @ $5 = 500
600 units $3,100 600 units $4,300
Income would have been $1,200 ($4,300 vs. $3,100) greater if the company used FIFO instead of LIFO.
Ex. 163
Dixen Company sells many products. Whamo is one of its popular items. Below is an analysis of the inventory
purchases and sales of Whamo for the month of March. Dixen Company uses the periodic inventory system.
Purchases Sales
Units Unit Cost Units Selling
Price/Unit
3/1 Beginning inventory 100 $40
3/3 Purchase 60 $50
3/4 Sales 70 $80
3/10 Purchase 200 $55
3/16 Sales 80 $90
236
3/19 Sales 60 $90
3/25 Sales 40 $90
3/30 Purchase 40 $60
Instructions
(a) Using the FIFO assumption, calculate the amount charged to cost of goods sold for March. (Show
computations)
(b) Using the weighted average method, calculate the amount assigned to the inventory on hand on March
31. (Show computations)
(c) Using the LIFO assumption, calculate the amount assigned to the inventory on hand on March
31. (Show computations)
Purchases Sales
Units Unit Cost Units Selling Price/Unit
3/ Beginning inventory 100 $40
1
3/ Purchase 60 $50
3
3/ Sales 70 $80
4
3/ Purchase 200 $55
10
3/ Sales 80 $90
16
3/ Sales 60 $90
19
3/ Sales 40 $90
25
3/ Purchase 40 $60
30
400 250
(a) Using FIFO - the earliest units purchased were the first sold.
3/1 100 @ $40 = $ 4,000
3/3 60 @ 50 = 3,000
3/10 90 @ 55 = 4,950
250 units $11,950 = the cost of goods sold
(b) Calculate the weighted average unit cost:
$20,400 ÷ 400 = $51
$51 × units in ending inventory (400 available less 250 sold = 150)
$51 × 150 = $7,650
(c) There are 150 units in ending inventory. They are comprised of the first units purchased
when LIFO is assumed.
3/1 100 @ $40 = $4,000
3/3 50 @ $50 = 2,500
150 units $6,500 = ending inventory
Ex. 164
Yenn Company uses the periodic inventory system to account for inventories. Information related to Yenn
Company's inventory at October 31 is given below:
Octob 1 Beginning inventory 400 units @ $10.00 = $ 4,000
er
8 Purchase 800 units @ $10.40 = 8,320
16 Purchase 600 units @ $10.80 = 6,480
24 Purchase 200 units @ $11.60 = 2,320
Total units and cost 2,000 units $21,120
237
Instructions
1. Show computations to value the ending inventory using the FIFO cost assumption if 550 units remain on
hand at October 31.
2. Show computations to value the ending inventory using the weighted-average cost method if 550 units
remain on hand at October 31.
3. Show computations to value the ending inventory using the LIFO cost assumption if 550 units remain
on hand at October 31.
1. 550 units in ending inventory.
Under FIFO, the units remaining in inventory are the ones purchased most recently.
10/24 200 units @ $11.60 = $2,320 10/16 350 units @
10.80 = 3,780
550 units $6,100

Under average cost method, the weighted average cost per unit must be computed.
$21,120 ÷ 2,000 units = $10.56
550 units × $10.56 = $5,808
Under LIFO, the units remaining are the ones purchased earliest.
10/1 400 units @ $10.00 = $4,000 10/8 150 units @
10.40 = 1,560
550 units $5,560
Ex. 165
Sims Company is in the electronics industry and the price it pays for inventory is decreasing.
Instructions
Indicate which inventory method will:
a. provide the highest ending inventory.
b. provide the highest cost of goods sold.
c. result in the highest net income.
d. result in the lowest income tax expense.
e. produce the most stable earnings over several years.
Solution 165 (4 min.) a. LIFO
b. FIFO
c. LIFO
d. FIFO
e. Average cost
Ex. 166
Utley Company reported the following summarized annual data at the end of 2008:
Sales revenue $1,000,000
Cost of goods sold* 600,000
Gross margin 400,000
Operating expenses 250,000 Income before income taxes $ 150,000
*Based on an ending FIFO inventory of $250,000.
The income tax rate is 30%. The controller of the company is considering a switch from FIFO to LIFO. He has
determined that on a LIFO basis, the ending inventory would have been $200,000.
Instructions
(a) Restate the summary information on a LIFO basis.
(b) What effect, if any, would the proposed change have on Utley's income tax expense, net income, and
cash flows?
238
(c) If you were an owner of this business, what would your reaction be to this proposed change?
(a) Restate to a LIFO basis:
Sales revenue $1,000,0
00
Cost of goods sold*
650,000
Gross margin 350,000
Operating expenses
250,000
Income before income taxes $
100,000
*Ending inventory would be $50,000 less ($250,000 – $200,000 = $50,000) under LIFO, thereby
increasing cost of goods by $50,000.
(b) The taxes on the FIFO basis would be:
$150,000 ×.30 = $45,000
Leaving Net Income of $105,000 ($150,000 – $45,000 = $105,000).
The taxes on the LIFO basis would be:

$100,000 ×.30 = $30,000
Leaving Net Income of $70,000 ($100,000 – $30,000 = $70,000).
Solution 166 (cont.)
Switching to the LIFO basis will result in $15,000 less income tax expense and less net income of
$35,000. The cash effect is $15,000 ($45,000 – $30,000 = $15,000) saved in taxes if LIFO were used.
(c) Owners of the business may favor the LIFO basis since more cash will be available for use in the business.
LIFO results in more cash being retained in the business since less is paid out for income taxes.
Ex. 167
Compute the lower-of-cost-or-market valuation for Howe Company's total inventory based on the following:
Inventory Categories Cost Data Market Data
A $18,000 $17,200
B 14,000 14,600
C 21,000 20,500
Inventory Categories Cost Data Market Data LC

M
A $18,000 $17,200 $17,2
00
B 14,000 14,600 14,0
00
C 21,000 20,500
20,50
0
Total Valuation $51,7
00
239
Ex. 168
The controller of Lawn-Pro Company is applying the lower-of-cost-or-market basis of valuing its ending
inventory. The following information is available:
Cost
Lawnmowers: Market
Self-propelled $15,000 $17,0
00
Push type 19,000
18,00
0
Total 34,000
Snowblowers: 35,00
0
Manual 30,000 31,000
Self-start 19,000
21,00
0
Total 49,000
52,00
0
Total inventory $83,000 $87,0
00
Instructions
Compute the value of the ending inventory by applying the lower-of-cost-or-market basis.
Lower-of-cost-or-
Lawnmowers: market
Self-propelled $15,000
Push type 18,000
Snowblowers:
Manual 30,000
Self-start 19,000
Total inventory $82,000
Ex. 169
Wert Company is preparing the annual financial statements dated December 31, 2008. Information about
inventory stocked for regular sale follows:
Quantity Unit Cost Replacement Cost
Item on Hand When Acquired (market) at year end

A 50 $20 $19 B 100 45 45 C 20 60 62
D 40 40 37
Instructions
Compute the valuation for the December 31, 2008, inventory using the lower-of-cost-or-market basis.

Lower of Cost
Item Units or Market Extensi
on
A 50 $19 $
950
B 100 45 4,500
C 20 60 1,200
240
D 40 37 1,480
$8,130
Ex. 170
Dryer Company reported net income of $60,000 in 2008 and $80,000 in 2009. However, ending inventory was
overstated by $5,000 in 2008.
Instructions
Compute the correct net income for Dryer Company for 2008 and 2009.

2008 correct net income = $55,000 ($60,000 – $5,000)
2009 correct net income = $85,000 ($80,000 + $5,000)
Ex. 171
For each of the independent events listed below, analyze the impact on the indicated items at the end of the
current year by placing the appropriate code letter in the box under each item.
Code: O = item is overstated
U = item is understated NA = item is not affected
Items
Owner’s Cost of Net
Events
Assets Equity Goods Sold Income
1. A physical count of goods on hand at the end
of the current year resulted in some goods
being counted twice.
2. The ending inventory in the previous period
was overstated.
3. Goods purchased on account in December of
the current year and shipped FOB shipping
point were recorded as purchases, but were
not included in the count of goods on hand on
December 31 because they had not arrived
by December 31.
4. Goods purchased on account in December of
the current year and shipped FOB destination
were recorded as purchases, but were not
included in the count of goods on hand on
December 31 because they had not arrived
by December 31.
5. The internal auditors discovered that the
ending inventory in the previous period was
understated $15,000 and that the ending
inventory in the current period was overstated
$25,000.

Items
Owner’s Cost of Net

Events
Assets Equity Goods Sold Income
1. O O U O
2. NA NA O U
3. U U O U
241
4. NA U O U
5. O O U O
Ex. 172
Nolan's Hardware Store prepared the following analysis of cost of goods sold for the previous three years:
2007 2008
2009
Beginning inventory 1/1 $40,000 $18,000 $25,0
00
Cost of goods purchased 50,000 55,000
70,00
0
Cost of goods available for sale 90,000 73,000 95,0
00
Ending inventory 12/31 18,000 25,000
40,00
0
Cost of goods sold $72,000 $48,000 $55,0
00
Net income for the years 2007, 2008, and 2009 was $70,000, $60,000, and $55,000, respectively. Since net
income was consistently declining, Mr. Nolan hired a new accountant to investigate the cause(s) for the
declines.
The accountant determined the following:

1. Purchases of $25,000 were not recorded in 2007.
2. The 2007 December 31 inventory should have been $24,000.
3. The 2008 ending inventory included inventory costing $5,000 that was purchased FOB destination and in
transit at year end.
4. The 2009 ending inventory did not include goods costing $4,000 that were shipped on December 29 to
Sampson Plumbing Company, FOB shipping point. The goods were still in transit at the end of the year.
Instructions
Determine the correct net income for each year. (Show all computations.)

2007 2008 2009
Beginning inventory 1/1 $ 40,000 $29,000 $20,00
0
Cost of goods purchased (1) 75,000 55,000
70,000
Cost of goods available for sale 115,000 84,000 90,00
0
Ending inventory 12/31 (2) 24,000 (3) 20,000
40,000
Cost of goods sold $ 91,000 $64,000 $50,00
0
2007 2008 2009
Net Income previously reported $70,000 $60,000 $55,00
0
Add: Prior cost of goods sold 72,000 48,000 55,00
0
Less: Revised cost of goods sold (91,000) (64,000)
(50,00
0)
Corrected Net Income $51,000 $44,000 $60,00
0
242
(1) Additional purchases $25,000
(2) Additional ending inventory $6,000
(3) Less ending inventory $5,000
Ex. 173
Hill Pharmacy reported cost of goods sold as follows:
2008 2009
Beginning inventory $ 54,000 $
64,000
Cost of goods purchased 847,000
891,000
Cost of goods available for sale 901,000 955,00
0
55,000
Cost of goods sold $837,000 $900,00
0
Hill made two errors:

(1) 2008 ending inventory was overstated by $6,000.
(2) 2009 ending inventory was understated by $15,000.
Instructions
Assuming the errors had not been corrected, indicate the dollar effect that the errors had on the items
appearing on the financial statements listed below. Also indicate if the amounts are overstated (O) or
understated (U).
2008 2009
Overstated/ Overstated/
Amount Understated Amount Understated
Total assets $_________ _______ $_________ _______
Owner’s equity $_________ _______ $_________ _______
Cost of goods sold $_________ _______ $_________ _______
Net income $_________ _______ $_________ _______

2008 2009
Overstated/ Overstated/
Amount Understated Amount Understated
Total assets $6,000 O $15,000 U
Owner’s equity $6,000 O $15,000 U
Cost of goods sold $6,000 U $21,000 O
Net income $6,000 O $21,000 U
243
Correct cost of goods sold:
2008 2009
Cost of goods purchased 847,000 891,000
Cost of goods available for sale 901,000 949,000
Ending inventory 58,000 70,000
Cost of goods sold $843,000 $879,000
Ex. 174
The following information is available for Manning Company:
Beginning inventory $
60,000
00
00
Sales 750,0
00
Instructions
Compute each of the following:
(a) Inventory turnover.
(b) Days in inventory.

$600,000 $600,000
(a) Inventory turnover: ———————————— = ———— = 7.5
($60,000 + $100,000) ÷ 2 $80,000
365
(b) Days in inventory: —— = 48.7 days
7.5
a
Ex. 175
Vaughn Company uses the perpetual inventory system and the LIFO method. The following information is
available for the month of May:
May 1 Beginning inventory 20 units @ $5

10 Purchase 20 units @ $8 15 Sales 15
units
18 Purchase 10 units @ $9
21 Sales 15 units
30 Purchase 10 units @ $10
Instructions
Prepare a schedule to show cost of goods sold and the value of the ending inventory for the month of May.
244
a
Cost of goods sold:
May 15 sale 15 units × $8 = $120
May 21 sale 10 units × $9 = 90
5 units × $8 = 40
30 units $250 Cost of goods sold
Ending inventory:
May 1 20 units × $5 = $100
May 30 10 units × $10 = 100
30 units $200 Ending inventory
a
Ex. 176
Romano Company uses the perpetual inventory system and had the following purchases and sales during
March.
Purchases Sales
Units Unit Cost Units Selling
Price/Unit
3/1 Beginning inventory 100 $40
3/3 Purchase 60 $50
3/4 Sales 70 $80
3/10 Purchase 200 $55
3/16 Sales 80 $90
3/19 Purchase 40 $60
3/25 Sales 120 $90
Instructions
Using the inventory and sales data above, calculate the value assigned to cost of goods sold in March and to
the ending inventory at March 31 using (a) FIFO and (b) LIFO.
a
Solution 176 (20 min.) a) FIFO
Da Purchases Sales Balance

te
3/1 (100 @ $40) $4,000
3/3 (60 @ $50) $3,000 (100 @ $40)
(60 @ $50) $7,000
3/4 (70 @ $40) $2,800 (30 @ $40)
(60 @ $50) $4,200
3/1 (200 @ $55) $11,000 (30 @ $40)
0
(60 @ $50)
(200 @ $55) $15,200
3/1 (30 @ $40) (10 @ $50)
6
(50 @ $50) $3,700 (200 @ $55) $11,500
3/1 (40 @ $60) $2,400 (10 @ $50)
9
(200 @ $55)
(40 @ $60) $13,900
3/2 (10 @ $50) (90 @ $55)
5
(110 @ $55) $6,550 (40 @ $60) $7,350
March cost of goods sold = $13,050 ($2,800 + $3,700 + $6,550)

March 31 inventory = $7,350
245
a
Solution 176 (cont.) b) LIFO
Da Purchases Sales Balance

te
3/1 (100 @ $40) $4,000
3/3 (60 @ $50) $3,000 (100 @ $40)
(60 @ $50) $7,000
3/4 (60 @ $50)
(10 @ $40) $3,400 (90 @ $40) $3,600
3/1 (200 @ $55) $11,000 (90 @ $40)
0
(200 @ $55) $14,600
3/1 (80 @ $55) $4,400 (90 @ $40)
6
(120 @ $55) $10,200
3/1 (40 @ $60) $2,400 (90 @ $40)
9
(120 @ $55)
(40 @ $60) $12,600
3/2 (40 @ $60) (90 @ $40)
5
(80 @ $55) $6,800 (40 @ $55) $5,800
March cost of goods sold = $14,600 ($3,400 + $4,400 + $6,800)

March 31 inventory = $5,800
a
Ex. 177
Adler Department Store prepares monthly financial statements but only takes a physical count of merchandise
inventory at the end of the year. The following information has been developed for the month of July:
At Cost At
Retail
50,000
Merchandise purchases 115,000 150,0
00
The net sales for July amounted to $140,000.
Instructions
Use the retail inventory method to estimate the ending inventory at cost for July. Show all computations to
support your answer.
a
At Cost At Retail
50,000
Merchandise purchases 115,000
150,000
Goods available for sale $150,000 200,00
0
Net sales
140,000
(1) Ending inventory at retail $
60,000
(2) Cost to retail ratio = 75% ($150,000 ÷ $200,000).
(3) Ending inventory at cost = ($60,000 × 75%) = $45,000.
246
a
Ex. 178
Horne Company suffered a loss of its inventory on March 28 due to a fire in its warehouse. As a basis for filing
a claim with its insurance company, Horne Company developed the following information:
March net sales through March 28 $360,0

00
Beginning Inventory, March 1 150,0
00
Merchandise purchases through March 28 180,0
00
The company has experienced an average gross profit rate of 35% in the past and this rate appears to be
appropriate in the current period.
Instructions
Using the gross profit method, prepare an estimate of the cost of the inventory destroyed by fire on March 28.
Show all computations in good form.
a
Net sales $360,0
00
Less: Estimated gross profit ($360,000 × 35%)
126,00
0
Estimated cost of goods sold $234,0
00
00
Merchandise purchases
180,00
0
Goods available for sale 330,0
00
Less: Estimated cost of goods sold
234,00
0
Estimated cost of ending inventory destroyed by fire $
96,000
a
Ex. 179
The inventory of Snider Company was destroyed by fire on April 1. From an examination of the accounting
records, the following data for the first three months of the year are obtained:
Sales $185,0
00
Sales Returns and Allowances 5,000
Purchases 90,000
Freight-In 3,500
Purchase Returns and Allowances 4,000
Instructions
Determine the merchandise lost by fire, assuming a beginning inventory of $60,000 and a gross profit rate of
40% on net sales.
a
Net Sales ($185,000 – $5,000) $180,000
Less: Estimated gross profit (40% × $180,000) 72,000
Estimated cost of goods sold $108,000
247
Cost of goods purchased ($90,000 – $4,000 + $3,500) 89,500
Cost of goods available for sale 149,500 Less: Estimated cost of good sold
108,000
Estimated cost of merchandise lost $ 41,500
a
Ex. 180
Hyland Company reports goods available for sale at cost, $90,000. Beginning inventory at retail is $40,000
and goods purchased during the period at retail were $80,000. Sales for the period amounted to $88,000.
Instructions
Determine the estimated cost of the ending inventory using the retail inventory method.
a
At Cost At
Retail
Beginning inventory $
40,000
Goods purchased
80,000
Goods available for sale $90,000 120,0
00
Net sales
88,000
Ending inventory $
32,000
First calculate the cost to retail ratio.

$90,000 ÷ $120,000 = 75%
Apply this ratio to the ending inventory at retail.

$32,000 × .75 = $24,000
$24,000 is the estimated cost of the ending inventory.
Ex. 9-139—Lower-of-cost-or-market.
Determine the proper unit inventory price in the following independent cases by applying the lower of cost or
market rule. Circle your choice.
1 2 3 4 5
Cost $8.05 $10.50 $11.75 $5.00
Net realizable value 8.85 9.80 12.20 4.25 6.90
Net realizable value less normal profit 8.15 9.00 11.40 3.75 5.70
Market replacement cost 7.90 10.10 12.50 3.80 5.40
Solution 9-139
Case 1 $ 8.05 Case 4 $3.80
Case 2 $9.80 Case 5 $5.70
Case 3 $11.75
248
Determine the unit value that should be used for inventory costing following "lower of cost or market value" as
described in ARB No. 43.
A B C D E F
Cost $2.35 $2.45 $2.15 $2.54 $2.34 $2.4
0
Replacement cost 2.26 2.55 2.20 2.52 2.33 2.4
6
Net realizable value 2.50 2.50 2.50 2.48 2.50 2.5
0
Net realizable value less normal profit 2.32 2.30 2.30 2.30 2.30 2.3
0
Solution 9-140
Case A $2.32 Case D $2.48
Case B $2.45 Case E $2.33
Case C $2.15 Case F $2.40
Assume in each case that the selling expenses are $10 per unit and that the normal profit is $5 per unit.
Calculate the limits for each case. Then enter the amount that should be used for lower of cost or market.
Selling Replacement
Price Upper Limit Cost Lower Limit Cost LCM
(a) $54 $______ (b) 47 $38 $______ $40 $_____

______ (c) 56 ______ (d) 48 36 ______ 40 _
______ 39 ______ 40 _____

_
42 ______ 40
_____
_
Solution 9-141 _____
_
Upper Limit Lower Limit
(a) $44 $39 (b) 37 32 (c) 46 41
(d) 38 33 LCM
$39
36
40
38
The December 31, 2012 inventory of Gwynn Company consisted of four products, for which certain
information is provided below.
Replacement Estimated Expected Normal Profit
Product Original Cost Cost Disposal Cost Selling Price on Sales
A $25.00 $22.00 $40.00 $6.50 $37.50 20%
B $42.00 $115.00 $12.00 $48.00 25%
C $120.00 $15.80 $25.00 $160.00 30%
D $16.00 $3.00 $22.00 10%
Instructions
Using the lower-of-cost-or-market approach applied on an individual-item basis, compute the inventory
valuation that should be reported for each product on December 31, 2012.
Solution 9-142
Lower-of-
Designated Cost-
or-
Product Ceiling Floor Market Cost Market
249
A $37.50 – $6.50 $31.00 – $8.00 $23.50 $25.00 $23.50
= $31.00 = $23.50
B $48.00 – $12.00 $36.00 – $12.00 $36.00 $42.00 $36.00
= $36.00 = $24.00
C $160.00 – $25.00 $135.00 – $48.00
$115.00 $120.00 $115.00
= $135.00 = $87.00
D $22.00 – $3.00 $19.00 – $2.20
= $19.00 = $16.80 $16.80 $16.00 $16.00
At 12/31/12, the end of Jenner Company's first year of business, inventory was $4,100 and $2,800 at cost and
at market, respectively.
Following is data relative to the 12/31/13 inventory of Jenner:
Original Net Net Realizable Appropriate
Cost Replacement Realizable Value Less Inventory
Ite Per Unit Cost Value Normal Profit Value
m $ .65 $ .45
A .45 . .40 .
B 70 75
C .75 .65
D .90 .85
E
Selling price is $1.00/unit for all items. Disposal costs amount to 10% of selling price and a "normal" profit is
30% of selling price. There are 1,000 units of each item in the 12/31/13 inventory.
Instructions
(a) Prepare the entry at 12/31/12 necessary to implement the lower-of-cost-or-market procedure assuming
Jenner uses a contra account for its balance sheet.
(b) Complete the last three columns in the 12/31/13 schedule above based upon the lower-ofcost-or-market
rules.
(c) Prepare the entry(ies) necessary at 12/31/13 based on the data above.
(d) How are inventory losses disclosed on the income statement?
Solution 9-143
(a) Loss Due to Market Decline of Inventory.................................... 1,300

Allowance to Reduce Inventory to Market...................... 1,300
(b) Original Net Net Realizable Appropriate
Cost Replacement Realizable Value Less Inventory
Item Per Unit Cost Value Normal Profit Value
A $ .65 $ .45 $ .90 $ .60 $ .60
B .45 .40 .90 .60 .45 C .70 .75 .90 .60 .70
D .75 .65 .90 .60 .65
E .90 .85 .90 .60 .85
$3.45 $3.25*
*$3.25 × 1,000 = $3,250
(c) Allowance to Reduce Inventory to Market.................................. 1,300
Cost of Goods Sold........................................................ 1,300
Loss Due to Market Decline of Inventory................................... 200

Allowance to Reduce Inventory to Market...................... (Cost of 200
inventory at 12/31/07 = $7,250)
OR
250
A student can record a recovery of $1,100.
(d) Inventory losses can be disclosed separately (below gross profit in operating expenses) or they can be
shown as part of cost of goods sold.
Ex. 9-144 – Relative sales value method.

Doran Realty Company purchased a plot of ground for $900,000 and spent $2,100,000 in developing it for
building lots. The lots were classified into Highland, Midland, and Lowland grades, to sell at $120,000, $90,000,
and $60,000 each, respectively.
Instructions
Complete the table below to allocate the cost of the lots using a relative sales value method.
No. of Selling Total % of Apportioned Cost
Grade Lots Price Revenue Total Sales
20
Total $ $ Per Lot
Highland $ 40 $ $
Midland $ 100 $ Lowland $
160 $ $
Solution 9-144
No. of Selling Total % of Apportioned Cost
Grade Lots Price Revenue Total Sales Total Per Lot
Highland 20 $120,000 $ 2,400,000 20% $ 600,000 $30,000 Midland 40 $90,000 3,600,000 30% 900,000
$22,500
Lowland 100 $60,000 6,000,000 50% 1,500,000 $15,000
160 $12,000,000 $3,000,000
Ex. 9-145—Gross profit method.
An inventory taken the morning after a large theft discloses $60,000 of goods on hand as of March 12. The
following additional data is available from the books:
Inventory on hand, March 1 $ 84,000 Purchases received, March 1 –

11 63,000
Sales (goods delivered to customers) 105,000
Past records indicate that sales are made at 50% above cost.
Instructions
Estimate the inventory of goods on hand at the close of business on March 11 by the gross profit method and
determine the amount of the theft loss. Show appropriate titles for all amounts in your presentation.
Solution 9-145
Beginning Inventory $ 84,000
Purchases 63,000
Goods Available 147,000
Goods Sold ($105,000 ÷ 150%) 70,000
Estimated Ending Inventory 77,000
Physical Inventory 60,000 Theft Loss $ 17,000

On January 1, a store had inventory of $48,000. January purchases were $46,000 and January sales were
$80,000. On February 1 a fire destroyed most of the inventory. The rate of gross profit was 25% of cost.
251
Merchandise with a selling price of $7,500 remained undamaged after the fire. Compute the amount of the fire
loss, assuming the store had no insurance coverage. Label all figures.
Solution 9-146
Beginning Inventory $ 48,000
Purchases 46,000
Goods available 94,000
Cost of sale ($80,000 ÷ 125%) (64,000)
Estimated ending inventory 30,000
Cost of undamaged inventory ($7,500 ÷ 125%) (6,000)
Estimated fire loss $24,000

Utley Co. prepares monthly income statements. Inventory is counted only at year end; thus, month-end
inventories must be estimated. All sales are made on account. The rate of mark-up on cost is 20%. The
following information relates to the month of May.
Accounts receivable, May 1 $21,000

Accounts receivable, May 31 15,000 Collections of accounts during May 90,000
Inventory, May 1 45,000
Purchases during May 58,000
Instructions
Calculate the estimated cost of the inventory on May 31.
Solution 9-147
Collections of accounts $ 90,000
Add accounts receivable, May 31 15,000
Deduct accounts receivable, May 1 (21,000)
Sales during May $ 84,000
Inventory, May 1 $ 45,000

Purchases during May 58,000 Goods available 103,000
Cost of sales ($84,000 ÷ 120%) (70,000) Estimated cost of inventory, May 31 $ 33,000
Ex. 9-148—Comparison of inventory methods.

In the cases cited below, five different conditions are possible when X is compared with Y. These possibilities
are as follows:
a. X equals Y d. X is equal to or greater than Y
b. X is greater than Y e. X is equal to or less than Y
c. X is less than Y
Instructions
In the space provided show the relationship of X and Y for each of the following independent statements.
D ____ 1. "Cost or market, whichever is lower," may be applied to (1) the inventory as a whole or to (2)
categories of inventory items. Compare (X) the reported value of inventory when procedure (1)
is used with (Y) the reported value of inventory when procedure (2) is used.
C ____ 2. Prices have been rising steadily. Physical turnover of goods has occurred approximately 4 times in
the last year. Compare (X) the ending inventory computed by LIFO method with (Y) the same
ending inventory computed by the moving average method.
E ____ 3. The retail inventory method has been used by a store during its first year of operation. Compare (X)
252
markdown cancellations with (Y) markdowns.
C ____ 4.
Prices have been rising steadily. At the beginning of the year a company adopted a new inventory
method; the physical quantity of the ending inventory is the same as that of the beginning inventory.
Compare (X) the reported value of inventory if LIFO was the new method with (Y) the reported value of
inventory if FIFO was the new method.
B____ 5.
Prices have been rising steadily. Physical turnover of goods has occurred five times in the last year.
Compare (X) unit prices of ending inventory items at moving average pricing with (Y) those at weighted
average pricing.
PROBLEMS
Pr. 9-149—Gross profit method.
On December 31, 2012 Felt Company's inventory burned. Sales and purchases for the year had been
$1,600,000 and $980,000, respectively. The beginning inventory (Jan. 1, 2012) was $170,000; in the past
Felt's gross profit has averaged 40% of selling price.
Instructions
Compute the estimated cost of inventory burned, and give entries as of December 31, 2012 to close
merchandise accounts.
Solution 9-149
Add: Purchases 980,000
Cost of goods available 1,150,000
Sales $1,600,000
Less 40% (640,000) 960,000
Estimated inventory lost $ 190,000
Sales ................................................................................................ 1,600,000

Income Summary ................................................................. 1,600,000
Cost of Goods Sold.......................................................................... 960,000

Fire Loss........................................................................................... 190,000
Inventory............................................................................... 170,000
Purchases............................................................................. 980,000
Pr. 9-150—Retail inventory method.

When you undertook the preparation of the financial statements for Telfer Company at January 31, 2013, the
following data were available:
At Cost At Retail
Inventory, February 1, 2012 $70,800 $ 98,500
Markdowns 35,000
Markups 63,000
Markdown cancellations 20,000
Markup cancellations 10,000
Purchases 219,500 294,00
0
Sales 325,00
0
Purchases returns and allowances 4,300 5,500
Sales returns and allowances 10,000
Instructions
253
Compute the ending inventory at cost as of January 31, 2013, using the retail method which approximates
lower of cost or market. Your solution should be in good form with amounts clearly labeled.
Solution 9-150
At Cost At Retail
Beginning inventory, 2/1/12 $ 70,800 $ 98,500
Purchases $219,500 $294,000
Less purchase returns 4,300 215,200 5,500 288,500
Totals $286,000 387,000
Add markups (net) 53,000
Totals 440,00
0
Deduct markdowns (net) 15,000
Sales price of goods available 425,000 Sales less sales returns 315,000
Ending inventory, 1/31/13 at retail $ 110,000
Ending inventory at cost: Ratio of cost to retail =
$286,000 ÷ $440,000 = 65%;
$110,000 × 65% = $71,500 $ 71,500
*Pr. 9-151—Retail inventory method.

The records of Lohse Stores included the following data:
Inventory, May 1, at retail, $14,500; at cost, $10,440
Purchases during May, at retail, $42,900; at cost, $31,550
Freight-in, $2,000; purchase discounts, $250
Additional markups, $3,800; markup cancellations, $400; net markdowns, $1,300
Sales during May, $44,500
Instructions
Calculate the estimated inventory at May 31 on a LIFO basis. Show your calculations in good form and label
all amounts.
254
*Solution 9-151
Retail Ratio
$14,500 .72
Purchases 31 ,550 42,900
Cost
Inventory, May 1 $10,440
Freight-in 2,000
Purchase discounts (250)
Net markups 3,400
Net markdowns (1,300
)
Totals excluding beginning inventory 33,300 45,000 .74
Goods available $43,740 59,500
Sales (44,500)
Inventory, May 31 $15,000
Estimated inventory, May 31 ($15,000 × .72) $ 10,800
*Pr. 9-152—LIFO retail inventory method, fluctuating prices.

Flint Department Store wishes to use the retail LIFO method of valuing inventories for 2013. The appropriate data are as
follows:
At Cost At Retail
December 31, 2012 inventory (base layer) $1,250,000 $2,100,000
Purchases (net of returns, allowances, markups, and markdowns) 2,100,000 3,500,000
Sales 3,080,000
Price index for 2013 105
Instructions
Complete the following schedule (fill in all blanks and show calculations in the parentheses):
Computation of Retail Inventory for 2013 Cost Retail

Ratio
$1,250,000 $2,100,000
Inventory, December 31, 2012
Purchases (net of returns, allowances, markups, and markdowns)
%
Total available
$
____________________________________
Inventory, December 31, 2013, at retail $

*Pr. 9-152 (Cont.)
Adjustment of Inventory to LIFO Basis Cost Retail
Ending inventory at base year prices

$
( )
Beginning inventory at base year prices $
Increase at base year prices $

Increase at 2013 retail ( ) $
Increase at 2013 cost ( )
$
Inventory, December 31, 2013, at LIFO cost
*Solution 9-152
Rati
Computation of Retail Inventory for 2013 Cost Retail o
Inventory, December 31, 2012 $1,250,000 $2,100,000
Cost Retail
$146,000 $220,00
480,000 0
80,000 700,00
Inventory, January 1, 2012 0
Purchases
Freight-in 750,00
Sales 0
Net markups 160,000
Net markdowns 60,000
Purchases (net of returns, allowances, markups, and
markdowns) 2,100,000 3,500,000 60%
Total available $3,350,000 5,600,000
Less: Sales 3,080,000
Inventory, December 31, 2013, at retail $2,520,000 Ending
inventory at
base year prices
Adjustment of Inventory to LIFO Basis Cost Retail
($2,520,000 ÷ 1.05) $2,400,000
Beginning inventory at base year prices $1,250,000 2,100,000
Increase at base year prices $ 300,000
Increase at 2013 retail ($300,000 × 1.05) $ 315,000

Increase at 2013 cost ($315,000 × 60%) 189,000 Inventory, December 31, 2013 at LIFO cost
$1,439,000
*Pr. 9-153—LIFO retail inventory method, stable prices.

Potter Variety Store uses the LIFO retail inventory method. Information relating to the computation of the inventory at
December 31, 2012, follows:
Instructions
Assuming that there was no change in the price index during the year, compute the inventory at December 31, 2012,
using the LIFO retail inventory method.
*Solution 9-153
Potter Variety Store
LIFO Retail Computation
December 31, 2012
At Cost At Retail Rati
o
Inventory, January 1, 2012 $146,000 $ 220,000
Purchases 480,000 700,000
Freight-in 80,000
Net markups 160,000
Net markdowns (60,000)
Total (excluding beginning inventory) 560,000 800,000 70%
Total (including beginning inventory) $706,000 1,020,000
Less sales 750,000
Inventory, Dec. 31, 2012, at retail $ 270,000
Ending inventory $ 270,000
Beginning inventory $146,000 (220,000)
Increment $ 50,000
Increment at cost ($50,000 × 70%) 35,000 Ending inventory at LIFO cost
$181,000
*Pr. 9-154—Dollar-value LIFO-retail method.

The records of Heese Stores provided the following data for the year:
Cost Retail
(Base inventory) Inventory, January 1 $150,000 $ 250,000
Net purchases 830,800 1,318,000
Sales 1,185,000
Other data are: Freight-in, $14,000; net markups, $8,000; net markdowns, $6,000; and the price index for the year is
110.
Instructions
Determine the approximate valuation of the final inventory by the dollar-value, LIFO-retail method.
Label all figures.
Cost Retail Ratio
*Solution 9-154
Retail Ratio
$ 250,000
Net purchases 830,800 1,318,000
Freight-in 14,000
Net markups 8,000
Cost
Inventory, January 1 $150,000

Totals excluding beginning inventory 844,800 1,320,000 .64
Goods available $994,800 1,570,000
Sales (1,185,000)
Ending inventory $ 385,000
Ending inventory deflated ($385,000 ÷ 1.10) $ 350,000
Base inventory $150,000 (250,000)
Layer added $ 100,000
New layer at end of year dollars ($100,000 × 1.10 × .64) 70,400 Estimated inventory at
dollar value, LIFO $220,400
*Pr. 9-155—Retail LIFO.

Klein Book Store uses the conventional retail method and is now considering converting to the LIFO retail
method for the period beginning 1/1/13. Available information consists of the following:
Following is a schedule showing the computation of the cost of inventory on hand at 12/31/12 based on the
conventional retail method.
Cost Retail Ratio
Inventory 1/1/12 $ 12,500 $ 22,500 Purchases (net) 250,000 347,500
Net markups — 5,000
Goods available $262,500 375,000 70%
Instructions
(a) Prepare the journal entry to convert the inventory from the conventional retail to the LIFOretail method.
Show detailed calculations to support your entry.
(b) Prepare a schedule showing the computation of the 12/31/13 inventory based on the LIFOretail method as
adjusted for fluctuating prices. Without prejudice to your answer to (a) above, assume that you computed
the 1/1/13 inventory (retail value $49,000) under the LIFO retail method at a cost of $35,000.
*Solution 9-155
(a) Cost Retail
Goods available $262,500 $375,000
Less: Beginning inventory (12,500) (22,500)
Cost to retail $250,000 $350,000
5/7 × $56,000 = $40,000 – $39,200 = $800 adjustment
Inventory................................................................................... 800
Adjustment to Record Inventory at Cost......................... 80
0
Rati
(b) Cost Retail o
Inventory $ 34,000 $ 49,000
Purchases 245,000 345,000
Net markups 10,000
Total 245,000 350,000 70%
Total goods available $279,000 399,000
Sales (322,000)
Ending inventory at retail—end of year dollars $ 77,000
Ending inventory deflated ($77,000 ÷ 1.10) $ 70,000
Beginning $ 35,000 49,000
Layer added ($21,000 × 1.10 × 70%) 16,170 $ 21,000
Ending inventory at cost $ 51,170
IFRS QUESTIONS
True / False
1. IFRS permits an entity to reverse inventory write-downs in certain situations, whereas U.S. GAAP does
not. T
2. IFRS defines market as replacement cost subject to certain constraints. F
3. IFRS uses a ceiling to determine market. F
4. Similar to U.S. GAAP, certain agricultural products and mineral products can be reported at net realizable
value using IFRS. T
5. IFRS records market in the lower-of-cost-or-market differently than U.S. GAAP. T

1. Where is the authoritative IFRS guidance related to accounting and reporting for inventories found?
a. IAS 2
b. IAS 18
c. IAS 41
d. All of these standards deal with inventory.
2. All of the following are key similarities between U.S. GAAP and IFRS with respect to accounting for
inventories except
a. guidelines on ownership of goods are similar.
b. costs to include in inventories are similar.
c. LIFO cost flow assumption where appropriate is used by both sets of standards.
d. fair value valuation of inventories is prohibited by both sets of standards.
3. All of the following are key differences between U.S. GAAP and IFRS with respect to accounting for
inventories except the
a. definition of the lower-of-cost-or-market test for inventory valuation differs between U.S. GAAP and
IFRS.
b. inventory basis determination for writedowns differs between U.S. GAAP and IFRS.
c. guidelines are more principles based under IFRS than they are under U.S. GAAP.
d. average costing method is prohibited under IFRS.
4. Alonzo Company in Italy prepares its financial statements in accordance with IFRS. In 2012, it reported
cost of goods sold of €600 million and average inventory of €150 million. What is Alonzo's inventory
turnover ratio?
a. 4 days
b. 25 days
c. 91.25 days
d. 100 days
5. Starfish Company (a company using U.S. GAAP and LIFO inventory method) is considering changing to
IFRS and the FIFO inventory method. How would a comparison of these methods affect Starfish's
financials?
a. During a period of inflation, the current ratio would decrease when IFRS and the FIFO inventory
method are used as compared to U.S. GAAP and LIFO.
b. During a period of inflation, the taxes will decrease when IFRS and the FIFO inventory method are
used as compared to U.S. GAAP and LIFO.
c. During a period of inflation, net income would be greater if IFRS and the FIFO inventory
method are used as compared to U.S.GAAP and LIFO.
d. During a period of inflation, working capital would decrease when IFRS and the FIFO inventory
method are used as compared to U.S. GAAP and LIFO.
6. Which of the following statements is true regarding IFRS and inventories?

a. In order to determine market valuation of inventories, IFRS uses a ceiling and a floor.
b. IFRS permits the option of valuing inventories at fair value.
c. With respect to inventories, IFRS defines market as net realizable value.
d. IFRS allows inventory to be written up above its original cost.
7. State Company manufactured a forklift machine at a cost of $60,000. The product is sold for $66,000 at a
5% discount. The delivery costs are estimated to be $6,000. Under IFRS, how much should be the
carrying amount of this inventory?
a. $60,000
b. $66,000
c. $54,000
d. $56,700
8. The following information relates to Moore Company's inventory:

Cost of inventory = $860
Selling price of inventory = $1,000
Normal profit margin = 10% of selling price
Current replacement cost = $740
Cost of completion and disposal = $100
Under IFRS, which of the following would be the correct measurement value for the
inventory?
a. $860
b. $740
c. $1,000
d. $900
9. Assume that Darcy Industries had the following inventory values:
Inventory cost (on December 31, 2011) = $1,500
Inventory market (on December 31, 2011) = $1,350
Inventory net realizable value (on December 31, 2011) = $1,320
Inventory market (on June 30, 2012) = $1,560
Inventory net realizable value (on June 30, 2012) = $1,570
Under IFRS, what is the inventory carrying value on December 31, 2011?
a. $1,500
b. $1,350
c. $1,320
d. $1,390
10. Assume that Darcy Industries had the following inventory values:
Inventory cost (on December 31, 2011) = $1,500
Inventory market (on December 31, 2011) = $1,350
Inventory net realizable value (on December 31, 2011) = $1,320
Inventory market (on June 30, 2012) = $1,560
Inventory net realizable value (on June 30, 2012) = $1,570 Under IFRS,
what is the inventory carrying value on June 30, 2012?
a. $1,500
b. $1,560
c. $1,570
d. $1,320
1. In a perpetual inventory system,
a. LIFO cost of goods sold will be the same as in a periodic inventory system.
b. average costs are based entirely on unit cost simple averages.
c. a new average is computed under the average cost method after each sale.
d. FIFO cost of goods sold will be the same as in a periodic inventory system.
2. Company Y has the following inventory data:

August 1 Beginning inventory 20 units at
$10
8 Purchases 130 units at
$15
17 Sale 80 units
25 Purchases 30 units at
$20
30 Sale 60 units
Assuming that a perpetual inventory system is used, what is ending inventory (rounded) under the average
cost method for August? (DO NOT ROUND INTERMEDIATE CALCULATIONS). a. $641.33
b. $611.11
c. $800.00
d. $500.00
3. Simpson Inc. purchased inventory as follows:

Jan. 5 500 units at $10.00
Jan. 15 1,000 units at $15.00
Jan. 25 200 units at $20.00
What is the average unit cost of inventory? a. $14.12

b. $15.00
c. $13.00
d. $15.83
4. Delightful Discs has the following inventory data:

Nov. 1 Inventory 30 units @ $6.00
each
8 Purchase 120 units @ $6.45
each
each
each
A physical count of merchandise inventory on November 30 reveals that there are 100 units on hand. Ending
inventory under LIFO periodic inventory system is a. $657
b. $632
c. $1,269
d. $1,295
5. Hardaway Inc. purchased inventory as follows:
Jan. 10 200 units at $5.00
Jan. 20 500 units at $10.00
Jan. 30 800 units at $15.00
Hardaway Inc. had no beginning inventory and has 500 units on hand as of January 31. Assuming the
specific identification method is used and ending inventory consists of 100 units from the Jan. 10 purchase,
300 units from the Jan. 20 purchase, and 100 units from the Jan. 30 purchase, ending inventory would be
a. $13,000
b. $4,000
c. $7,500
d. $5,000
6. Hardaway Inc. purchased inventory as follows:

Jan. 10 200 units at $5.00
Jan. 20 500 units at $10.00
Jan. 30 800 units at $15.00
Hardaway Inc. had no beginning inventory and has 500 units on hand as of January 31. Assuming the
specific identification method is used and ending inventory consists of 100 units from the Jan. 10 purchase,
300 units from the Jan. 20 purchase, and 100 units from the Jan. 30 purchase, cost of goods sold would be
a. $13,000
b. $4,000
c. $7,500
d. $5,000
7. Baker Bakery Company just began business and made the following four inventory purchases in June:
June 1 150 units $
1,040
June 10 200 units 1,560
June 15 200 units 1,680
June 28 150 units
1,320
$5.6
00
A physical count of merchandise inventory on June 30 reveals that there are 210 units on hand. Using the
FIFO periodic inventory method, the amount allocated to ending inventory for June is a. $1,456
b. $1,508
c. $1,824
d. $1,848
8. Goods held on consignment are

a. never owned by the consignee.
b. included in the consignee’s ending inventory.
c. kept for sale on the premises of the consignor.
d. included as part of no one’s ending inventory.
9. Reeves Company is taking a physical inventory on March 31, the last day of its fiscal year. Which of the
following must be included in this inventory count?
a. Goods in transit to Reeves, FOB destination
b. Goods that Reeves is holding on consignment for Parker Company
c. Goods in transit that Reeves has sold to Smith Company, FOB shipping point
d. Goods that Reeves is holding in inventory on March 31 for which the related Accounts Payable is 15 days
past due
10. At December 31, 2019 Mohling Company’s inventory records indicated a balance of $632,000. Upon
further investigation it was determined that this amount included the following:
• $112,000 in inventory purchases made by Mohling shipped from the seller 12/27/19 terms FOB destination,
but not due to be received until January 2nd,
• $74,000 in goods sold by Mohling with terms FOB destination on December 27 th. The goods are not
expected to reach their destination until January 6th.
• $6,000 of goods received on consignment from Dollywood Company
What is Mohling’s correct ending inventory balance at December 31, 2019? a.

$520,000
b. $626,000
c. $440,000
d. $514,000
11. Zimmerman Inc. uses a periodic inventory system. Details for the inventory account for the month of
October are shown below:
Assume that on October 31, there is 80 units on hand. If the company uses FIFO, what is the value of
ending inventory?
a. $400
b. $335
c. $373
d. $360
12. Zimmerman Inc. uses a periodic inventory system. Details for the inventory account for the month of
October are shown below:
Assume that on October 31, there is 80 units on hand. If the company uses LIFO, what is the value of cost
of goods sold for October?
a. $1,000
b. $1,200
c. $1,065
d. $1,028
13. Nelson Corporation sells three different products. The following information is available on December 31:
Inventory Item Units Cost per unit Market value per unit
X 300 $4.00 $3.50
Y 600 $2.00 $1.50
Z 1,500 $3.00 $4.00
When applying the lower of cost or market rule to each item, what will Nelson's total ending inventory
balance be? a. $6,900
b. $6,450
c. $7,950
d. $6,600
14. Inventory costing methods place primary reliance on assumptions about the flow of
a. goods.
b. costs.
c. resale prices.
d. values.
15. The Boxwood Company sells blankets for $60 each. The following was taken from the inventory
records during May. The company had no beginning inventory on May 1.
Date Blankets Units Cost

May 3 Purchase 5 $20
10 Sale 3
17 Purchase 10 $24
20 Sale 6
23 Sale 3
30 Purchase 10 $30
Assuming that the company uses the perpetual inventory system, determine the COST OF GOODS SOLD
for the month of May using the LIFO inventory cost method. a. $364
b. $300
c. $268
d. $276
EXERCISES
1. Company M uses the perpetual inventory system. They want to calculate the cost of goods sold and the
value of their ending inventory using each of the following methods:
A) FIFO
B) LIFO
C)Average Cost Method
Use the information below along with the tables provided for each method.
1.
Exercise Solutions (Cont.)
1. (Cont.)
2. The Cain Company has just completed a physical inventory count at year end, December 31, 2017. Only the
items on the shelves, in storage, and in the receiving area were counted and costed on the FIFO basis. The
inventory amounted to $80,000. During the audit, the independent CPA discovered the following additional
information:
(a) There were goods in transit on December 31, 2017, from a supplier with terms FOB destination, costing
$10,000. Because the goods had not arrived, they were excluded from the physical inventory count.
(b) On December 27, 2017, a regular customer purchased goods for cash amounting to $1,000 and had
them shipped to a bonded warehouse for temporary storage on December 28, 2017. The goods were
shipped via common carrier with terms FOB shipping point. The customer picked the goods up from the
warehouse on January 4, 2018. Cain Company had paid $500 for the goods and, because they were in
storage, Cain included them in the physical inventory count.
(c) Cain Company, on the date of the inventory, received notice from a supplier that goods ordered earlier, at
a cost of $4,000, had been delivered to the transportation company on December 28, 2017; the terms
were FOB shipping point. Because the shipment had not arrived on December 31, 2017, it was excluded
from the physical inventory.
(d) On December 31, 2017, there were goods in transit to customers, with terms FOB shipping point,
amounting to $800 (expected delivery on January 8, 2018). Because the goods had been shipped, they
were excluded from the physical inventory count.
(e) On December 31, 2017, Cain Company shipped $2,500 worth of goods to a customer, FOB destination.
The goods arrived on January 5, 2017. Because the goods were not on hand, they were not included in
the physical inventory count.
(f) Cain Company, as the consignee, had goods on consignment that cost $3,000. Because these goods
were on hand as of December 31, 2017, they were included in the physical inventory count.
Instructions
Analyze the above information and calculate a corrected amount for the ending inventory. Explain the
basis for your treatment of each item.
2.
Start with $80,000
Item (a) – (Because the goods were shipped FOB destination title will
pass to Cain upon arrival. Properly excluded.)
Item (b) – 500 (Goods should be excluded. The customer accepted title
when the goods left Cain FOB shipping point.)
Item (c) + 4,000 (Goods belong to Cain. Title passed when supplier delivered
the goods to the transportation company.)
Item (d) – (Because the goods were shipped FOB shipping point Cain
no longer has title to these goods. Properly excluded.)
Item (e) + 2,500 (Goods were shipped FOB destination. Cain retains title until
the customer receives them.)
Item (f) – 3,000 (These goods are owned by the consignor, not the
consignee, and should not be included in Cain's inventory.)
Corrected inventory $83,000
3.
Hanlin Company uses the periodic inventory system to account for inventories. Information related to Hanlin
Company's inventory at January 31 is given below:
Januar 1 Beginning inventory 400 units @ $12.00 = $

y 4,80
0
8 Purchase 800 units @ $12.40 = 9,920
16 Purchase 600 units @ $12.80 = 7,680
24 Purchase 200 units @ $13.20 =
2,640
Total units and cost 2,000 units $25,0
40
Instructions
A. Show computations to value the ending inventory using the FIFO cost assumption if 600 units remain on
hand at January 31.
B. Show computations to value the ending inventory using the weighted-average cost method if 600 units
remain on hand at January 31.
C. Show computations to value the ending inventory using the LIFO cost assumption if 600 units remain on
hand at January 31.
A. 600 units in ending inventory.
Under FIFO, the units remaining in inventory are the ones purchased most recently.
1/24 200 units @ $13.20 = $2,640 (1/24 units × 1/24 cost)
1/16 400 units @ $12.80 = 5,120 ((1/31 units − 1/24 units) × 1/16 cost)
600 units $7,760
B. 600 units in ending inventory.

Under average cost method, the weighted-average cost per unit must be computed.
$25,040 ÷ 2,000 units = $12.52
600 units x $12.52 = $7,512 (Tot. cost/tot. units) × end. inv. units
C. 600 units in ending inventory.

Under LIFO, the units remaining are the ones purchased earliest.
1/1 400 units @ 12.00 = $4,800 1/1 units × 1/1 cost
1/8 200 units @ 12.40 = 2,480 ((1/31 units − 1/1 units) × 1/8 cost)
600 units $7,280
4. Wolf Camera Shop Inc. uses the lower-of-cost-or-market basis for its inventory. The following data are
available at December 31.
Market
Units Cost/Un Value/U
it nit
Cameras

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RECEIVABLE FINANCING ( PLEDGE, FACTORING, ASSIGNMENT)

NOTES RECEIVABLE (PROBLEMS)

LOANS RECEIVABLE (PROBLEMS)

Trade accounts receivable (current) P3,440,00

Past due trade accounts 640,000

Notes receivable dishonored 240,000

Consignment goods already sold (P160,000 x 90%) 144,000

Less due from consignee 144,000

Basis of allowance for doubtful accounts 4,320,000

Bad debt rate 5%

Add write-off of uncollectible accounts 128,000

Total 344,000 Less allowance account before adjustment 80,000

Doubtful accounts expense P264,000

Allowance for doubtful accounts (per books) 1,250,000

Customer accounts written off as uncollectible during 2006 300,000

Accounts receivable, net of allowance for doubtful accounts P9,500,000

Bad debts expense for 2006 840,000

Debit Credit Accounts receivable P4,100,000

Allowance for doubtful accounts 100,000

Net credit sales P7,500,000

Net sales 14,300,000 Multiply by bad debt rate 1 1/2%

Bad debt expense P 214,500

Net realizable value P15,700,000

Allowance for doubtful accounts 1/1/06 P170,00

Bad debt expense for 2006 P840,000

Accounts receivable P4,100,000

Allowance for bad debts P40,000

• Cash sales of the company represents 10% of gross sales.

1. The accounts receivable as of December 31, 2006 is

2. The allowance for doubtful accounts as of December 31, 2006 is

3. The net realizable value of accounts receivable as of December 31, 2006 is

4. The doubtful account expense for the year 2006 is

Divide by percentage of cash discount 0.02

Portion of AR that will be granted cash discounts 300,000

Divide by percentage of total AR estimated to take

advantage of the discount 0.10

Accounts receivable, 12/31/06 P3,000,000

Accounts receivable, 12/31/06 P3,000,000

Multiply by bad debt rate

[(P40,000/P1,000,000) x 1.5] 0.06

Allowance for doubtful accounts, 12/31/06 P 180,000

Accounts receivable, 12/31/06 P3,000,000

Less: Allowance for doubtful accounts P180,000

Allowance for sales discounts 6,000 186,000

Net realizable value, 12/31/06 P2,814,000

Allow. for doubtful accounts, 12/31/06 P180,000

Add accounts written off 44,000

Less: Allow. for doubtful accounts, 12/31/05 P40,000

Bad debt recoveries 3,000 43,000

Doubtful accounts expense for 2006 P181,000

Accounts receivable P3,600,000

During 2006, transactions relating to the accounts were as follows:

• Sales on account, P38,400,000.

1. The accounts receivable as of December 31, 2006 is

2. The allowance for doubtful accounts as of December 31, 2006 is

3. The net realizable value of accounts receivable as of December 31, 2006 is

Accounts receivable, 12/31/05 P 3,600,000

Add: Sales on account 38,400,000