INTRODUCTION TO FINANCIAL ACCOUNTING MGCR211 - All sections October 21 st, :00PM - 5:00PM SOLUTION. McGill ID:

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1 October 21, 2016 Midterm Examination INTRODUCTION TO FINANCIAL ACCOUNTING MGCR211 - All sections October 21 st, :00PM - 5:00PM SOLUTION Please pick your professor: Professor: Jorien Pruijssers Seda Oz Ralph Cecere Day & Time of your class: Student Name: McGill ID: INSTRUCTIONS: This is a CLOSED BOOK, CLOSED NOTES examination. SPACE IS PROVIDED on the examination to answer Parts A to G of the exam. CALCULATOR WITHOUT GRAPH FEATURES permitted ONLY. Translation dictionaries are allowed. This examination consists of a total of 19 pages, including the cover and extra sheet pages. All questions are to be answered on this examination paper. Answer the question in the space provided. Do not exceed the space allowed. Read each question carefully. Show your calculations and explain your reasoning. All companies are expected to be IFRS compliant unless stated otherwise and all amounts are material unless otherwise noted in the question. This examination is PRINTED ON BOTH SIDES of the paper. This examination paper MUST BE RETURNED. Marks PART A Multiple Choice Questions 10 Grade PART B Basic Accounting Equation 32 PART C Sale Transactions 12 PART D Trial Balance 6 PART E Independent Situations 15 PART F Ratio Analysis 10 PART G Revenue Recognition 15 TOTAL / 17

2 Part A: Multiple Choice Questions (10 Marks) There are 5 multiple choice questions in this section. Select the best answer for each of the following unrelated questions (unless otherwise noted). Answer each of these questions directly on your examination paper by circling your choice. If more than one answer is given for an item then that item will not be marked. Incorrect answers will be marked as zero. Marks will not be awarded for explanations. 1. Which of the following would violate the economic entity concept? a) reporting amounts owed to the company s suppliers as a liability on the balance sheet b) reporting equipment owned and used in the business as an asset in the balance sheet c) reporting withdrawals by the owner as a drawing in the statement of owner s equity d) reporting the owner s personal sailboat as an asset on the balance sheet. 2. The going concern assumption a) states that a company will not operate long enough to utilize assets and fulfill obligations b) assumes the company will continue to operate in the foreseeable future c) is inconsistent with the cost principle d) states that net worth is the most appropriate value at which to record assets 3. Which of the following statements is not true? a) Comparability means using different accounting principles from year to year within a company b) Faithful representation means information must be neutral, complete, and free from material error c) Relevant accounting information must be capable of making a difference in a user s decision d) For accounting information to be reliable, it must be verifiable 4. A business organized as a corporation a) is not a separate legal entity b) requires that shareholders be personally liable for the debts of the business c) has unlimited life d) has income tax disadvantages over a proprietorship or partnership 5. Which form of business would have its shares listed on a stock exchange? a) proprietorship b) partnership c) private corporation d) public corporation 2 / 17

3 Part B: Basic Accounting Equation (32 Marks) MARKING: EACH CORRECT BOX IS WORTH 1 MARK. Winter Music Company (WMC) is a retail company, specializing in musical instruments and related accessories. The company is structured as a private corporation and its owner is Sansa Stark. The company reports the following transactions and closes its books quarterly. Using the following table, analyze the effect of each transaction on the basic accounting equation for the first Quarter ended March 31, WMC uses a perpetual inventory system and uses gross method to record cash discounts. Required: For each transaction described below determine its impact on the accounting equation. Please use the table given in pages 4-5 for your answers. Do not leave any box blank. A blank answer will receive zero marks. Winter Music Company s balance sheet at the end of December 31, 2015 is given below. Cash $ 6 Accounts payable (inventory) $ 6 Accounts Receivable $ 15 Salaries payable $ 1 Merchandise Inventory $ 218 Unearned Revenue $ 12 Total Liabilities $ 19 Share capital $ 211 Retained Earnings $ 9 Total Assets $ 239 Total Liabilities & SE $ 239 In the first quarter of 2016 the following transactions occurred (where dates are not indicated, the transaction is a summary transaction for the quarter): (1) On January 1, 2016, WMC paid the December 2015 salary of $1 in cash. (2) On January 1, 2016, Sansa contributed $90 in cash to her company in exchange for 100 shares. (3) WMC sold $320 worth of items on credit. Cost of inventory sold was $115. (4) On January 1, 2016, WMC paid suppliers $6 in cash, the amount owed to the suppliers from a past transaction. (5) WMC collected $30 on account from customers. (6) On January 1, 2016, WMC bought office supplies for $120 financed partly by a $100 loan from the seller. Because WMC is a reliable customer, the seller decided not to charge any interest. (7) WMC delivered all the advance paid orders from customers outstanding on December 31, The cost of the inventory delivered was $8. The customer did not accept all the goods when they were shipped out since they had limited warehousing space to hold the goods. The customer promptly returned half of the goods to WMC by February 2016 and kept the other half. WMC put the returned items back in its warehouse which is waiting to be shipped out in the last quarter of (8) On January 17, 2016, WMC bought inventory on account from Lannister Ltd. for $120, with credit terms 1/10, n/30, FOB shipping point. (9) On January 19, 2016, the appropriate company paid freight costs of $15 on the inventory purchased on January 17, (10) On January 21, 2016, WMC received the items, purchased on January 17, After examining the order they had realized that some of the items were damaged. WMC promptly returned damaged items to Lannister Ltd. and was given a purchase allowance of $20. (11) On January 23, 2016 WMC paid the amount due to Lannister Ltd. in full. (12) Employee salaries for the first quarter of 2016 were $9 of which, at the end of the quarter, $1 was yet to be paid out. (13) On February 28, 2016, received $6 from a customer for goods to be delivered on December 1, / 17

4 Account Name Cash Acc. rec Prepaid Adv. ASSETS LIABILITIES SHAREHOLDERS' EQUITY PP ins. Inventory Office Supplies Acc. pay. Sal. pay. Unearned Revenue Div. pay Loan Pay. Share Capital Retained Earnings Transaction Transaction Transaction 3a Transaction 3b Transaction Transaction Transaction / 17

5 Account Name Cash Acc. rec Prepaid Adv. ASSETS LIABILITIES SHAREHOLDERS' EQUITY PP ins. Inventory Office Supplies Acc. pay. Sal. pay. Unearned Revenue Div. pay Loan Pay. Share Capital Retained Earnings Transaction 7a -6 6 Transaction 7b -4-4 Transaction Transaction Transaction 10 Transaction 11 Transaction 12 Transaction / 17

6 Part C: Sale Transactions (12 Marks) Hubu Corp. is a merchandising company and presents the following table, stating the date of sale, the amount of returns from customers (if any), and the date of payment from customers. The corporation uses gross method when recording cash discounts. Credit Sales Sales Returns Date of Collection Date Amount Terms Date Amount 4-Aug-16 $1,200 2/10, n/30 9-Aug Aug-16 2,400 3/10, n/30 15-Aug-16 $ Aug Aug-16 10,000 1/10, n/30 21-Aug-16 2, Aug-16 Required: 1. Calculate the cash received for each collection date. Make sure to show all your work. (4 Marks) Date of Sale Date of Collection Cash Collected Explanation 4-Aug 9-Aug $1,176 [Sales $1,200 Sales discount $24 ($1,200.02)] 12-Aug 17-Aug $1,552 [Sales $2,400 Sales return $800 $1,600; $1,600 Sales discount $48 ($1,600.03)] 18-Aug 30-Aug $8,000 [Sales $10,000 Sales return $2,000 $8,000; (Discount lapsed)] 6 / 17

7 2. Prepare the journal entries for the following transactions. Assume Hubu Corp. uses the perpetual inventory system. a. August 17 collection. (2 Marks) b. August 18 sale. Additional information: The merchandise sold cost $7,000 to Hubu Corp. (2 Marks) c. August 21 sales return. The merchandise returned cost $600 to Hubu Corp. (4 Marks) Oct. 28 Cash 1,552 Sales Discounts 48 Accounts Receivable 1,600 Aug. 18 Accounts Receivable 10,000 Sales Revenue 10,000 Cost of Goods Sold 7,000 Inventory 7,000 Aug 21 Sales Returns and Allowances 2000 Accounts Receivable 2000 Inventory 600 Cost of Goods Sold / 17

8 Part D: Trial Balance (6 Marks) MARKING: EACH CORRECTION IS WORTH 1 MARK. 2 MARKS FOR HAVING THE CORRECT AMOUNTS FOR TOTAL DEBITS AND CREDITS The trial balance of Winotte Limited shown below does not balance. WINOTTE LIMITED Trial Balance July 31, 2015 Debit Credit Cash $1,600 Accounts Receivable 6,600 Supplies 600 Equipment 9,000 Accounts Payable $9,300 Common Shares 1,941 Dividends 1,500 Service Revenue 15,200 Salaries Expense 4,100 Repair Expense 900 Income Tax Expense 2,000 Total $26,300 $26,441 An examination of the ledger and journal reveals the following: (1) Each of the above listed accounts has a normal balance. (2) Cash of $350 received from a customer on account was debited to Cash as $530 and credited to Accounts Receivable as $530. (3) Dividends of $300 paid to shareholders were posted as a credit to Dividends of $300 and a credit to Cash of $300. (4) Services were performed on account for a customer for $510. Accounts Receivable was debited $510 and Service Revenue was credited $51. Required: Prepare a corrected trial balance as of July 31, 2015 using the table below. 8 / 17

9 Answer WINOTTE LIMITED Trial Balance July 31, 2015 Debit Credit Adjustments / Corrections Debit Credit Cash $1, $1,420 Accounts Receivable 6, $6,780 Supplies 600 $600 Equipment 9,000 $9,000 Accounts Payable $9, Common Shares 1, Dividends 1, $2,100 Service Revenue 15, Salaries Expense 4,100 $4,100 Repair Expense 900 $900 Income Tax Expense 2,000 $2,000 Blank Space (if needed): Total $26,300 $26,441 $26,900 $26,900 9 / 17

10 PART E: Independent Situations (15 Marks) 1. On June 1, Ren, Inc. paid $12,000 for one year of rent in advance. In Ren s information system, the $12,000 was recorded as prepaid rent. Ren forgot to make the necessary adjusting entry before preparing its annual financial statements on December 31. Put an X in the appropriate box to show how each of these line items will be reported on Ren s financial statements. Dollar amounts are not required. (6 Marks) 1. Rent expense 2. Prepaid rent 3. Cash paid for rent 4. Total assets 5. Total liabilities 6. Total shareholders equity Overstated Understated Correctly Stated ANSWER: Overstated Understated Correctly Stated 1. Rent expense X 2. Prepaid rent X 3. Cash paid for rent X 4. Total assets X 5. Total liabilities X 6. Total shareholders equity X 2. Selina Meyer Inc. prepared the following condensed income statement using the cash basis of accounting: (5 marks) Selina Meyer INC. Income Statement, Cash Basis Year Ended December 31, 2015 Service revenue...$820,000 Expenses...640,000 Profit...$180,000 Additional data: (i) Depreciation on a company automobile for the year amounted to $9,000. This amount is not included in the expenses above. (ii) On January 1, 2015, paid for a two-year insurance policy on the automobile amounting to $1,800. This amount is included in the expenses above. (iii) Service revenue does not include $50,000 of services provided on account in 2015 for which payment will be received in It does, however, include $20,000 collected in 2015 for services performed in (iv) Expenses do not include $50,000 of expenses that were incurred in 2015 but won t be paid for until Required: Prepare a corrected income statement for the year ended December 31, 2015 using the accrual basis of accounting. Show calculations and explain each change. 10 / 17

11 Selina Meyer INC. Income Statement Year Ended December 31, 2015 Service revenue... $850,000 Expenses ,100 Profit... $151,900 Service revenue should include the $50,000 for services performed on account, but not the $20,000 collected in 2015 for services performance in The accrual basis states that revenue is recognized in the period when the service is performed. Revenue is calculated by adjusting the cash received to reflect this ($820,000 + $50,000 $20,000 $850,000). (2 marks) Expenses should include the $50,000 for expenses incurred but not yet paid. The accrual basis states that expenses should be reflected in the period when incurred. (1 mark) Expenses also should only include half of the $1,800 insurance premium since only onehalf of the two-year policy applies to The other $900 is an asset and should be reflected on the statement of financial position as prepaid insurance. Since the full $1,800 is included in Expenses, $900 will have to be removed. (1 mark) The $9,000 of depreciation for the automobile must be included as an expense in (1 mark) Expenses are calculated as: $640,000 + $50,000 $900 + $9,000 $698, / 17

12 3. Below is a series of cost of goods sold sections for two companies that use a periodic inventory system (in thousands): (4 Marks) Required: Co. A Co. B Beginning inventory A 35 Purchases 123 E Purchase returns and allowances B 9 Net purchases Freight in C 20 Freight out Cost of goods purchased 147 F Cost of goods available for sale 171 G Ending inventory D H Cost of goods sold Use the information given above and indicate the amount that corresponds to the letters in the table provided below. A 24 B 10 C 34 D 30 E 214 F 225 G 260 H / 17

13 Part F: Ratio Analysis (10 Marks) The following information has been adapted from the 2006 and 2005 annual reports of Margaery Tyrell Corporation's worldwide operations. Margaery Tyrell Corporation Income Statements For the Years Ended June Revenue $44,282 $39,788 $36,835 Operating expenses: Cost of goods sold 7,650 6,031 6,596 Research & development 6,584 6,097 7,735 Sales & marketing 9,818 8,563 8,195 General & administrative 3,758 4,536 5,275 Total operating expenses 27,810 25,227 27,801 Operating income 16,472 14,561 9,034 Investment income 1,790 2,067 3,162 Income before income taxes 18,262 16,628 12,196 Income tax expense 5,663 4,374 4,028 Net income $12,599 $12,254 $8,168 Additional information that might be useful: Cash dividends declared per common share $0.35 $3.40 $0.16 Weighted average shares outstanding 10,438 10,839 10,808 Market price per share $24.63 $ / 17

14 Margaery Tyrell Corporation Balance Sheets June Assets Current assets: Cash $ 6,714 $ 4,851 $ 14,304 Short-term investments 27,447 32,900 46,288 Accounts receivable 9,316 7,180 5,890 Inventory 1, Other current assets 4,055 3,315 3,663 Total current assets 49,010 48,737 70,566 Property & equipment, net 3,044 2,346 2,326 Long-term investments 9,232 11,004 12,210 Goodwill 3,866 3,309 3,115 Intangible assets, net Other long-term assets 3,906 4,920 5,582 Total assets $69,597 $70,815 $94,368 Liabilities & shareholders' equity Current liabilities: Accounts payable $ 2,909 $ 2,086 $ 1,717 Wages payable 1,938 1,662 1,339 Income taxes payable 1,557 2,020 3,478 Short-term unearned revenue 9,138 7,502 6,514 Other payables 6,900 3,607 1,921 Total current liabilities 22,442 16,877 14,969 Long-term unearned revenue 1,764 1,665 1,663 Other long-term liabilities 5,287 4,158 2,911 Total liabilities 29,493 22,700 19,543 Shareholders' equity: Common stock 59,005 60,413 56,396 Retained earnings (deficit) (18,901) (12,298) 18,429 Total shareholders' equity 40,104 48,115 74,825 Total liabilities & shareholders' equity $69,597 $70,815 $94, / 17

15 1. Compute the following ratios for 2006 and 2005 (round to two decimal places). (4 Marks) Current Ratio $49,010 / $22, :1 $48,737 / $16, :1 Gross Profit Ratio ($44,282-7,650) / $44, % ($39,788-6,031) / $39, % 2. Using your calculations above, comment on these ratios for the year (4 marks) CR assesses liquidity. The current ratio has deteriorated from 2005 to However, they are still above the 1:1 threshold. Current Ratio 2005: for every $1 in current liabilities, they had $2.89 current assets. 2006: for every $1 in current liabilities, they had $2.18 current assets The Gross Profit ratio assesses the profitability of the firm. From 2005 to 2006 the ratio deteriorated slightly. Gross Profit Ratio 2005: for every $1 in net sales, they earn a gross profit of $ : for every $1 in net sales, they earn a gross profit of $ Did the company rely mainly on debt or equity to finance its assets during 2006? Explain and support your answer. (2 marks) Comparison of Total Liabilities ($29,493) with total Shareholders equity ($40,104). Assets are mainly financed by equity. Proportion of Total liabilities: 42% (29493/69597) Proportion of Total shareholders equity: 58% (40104/69597) Another ratio that can be used: Debt-to-Equity Ratio (2006) $29,493 / $40, Assets are mainly financed by equity 1 mark for explaining (with appropriate ratio and/or analysis) 1 mark for concluding 15 / 17

16 Part G: Revenue Recognition (15 Marks) 1. Red-Hot-Deals Inc. (RHD) is a privately held online retailer that sells discounted electronics products. In order to boost their revenues and expand their customer base, RHD decided to launch a customer referral campaign which they aptly named, "Refer-a-Buddy Program". Existing customers that refer buddies to RHD receive a $40 credit towards purchase of any merchandise carried at the online store. The program is described as follows on the company website: As an existing customer, you will receive a $40 credit from Red-Hot Deals when a buddy of yours visits the online store website and purchases any item from us. Your buddy will be asked to enter your address so that after a purchase is made, a $40 credit will be applied to your account with us, credit to be applied against any future purchase by you. The program is open to all existing customers and there are no other restrictions. RHD management decided to run this program after considering the cost of acquiring new customers via other means such as hiring a marketing firm. The cost of acquiring a customer was quoted as $40 by a highly respected marketing firm that RHD had approached. Required: i. This is the first time RHD runs such a program and is not sure how to account for it. The president would like a brief explanation of how the $40 referral credit be recorded on RHD's Income Statement. He would also like to know when the $40 referral credit should be recognized. (5 Marks) The $40 referral credit is a marketing cost associated with acquiring a new customer. A marketing firm supports the fair value of such a program. There is too much uncertainty in measuring the cost as an asset; therefore the cost is expensed. Recognition: The referral credit would be recorded as soon as a valid sale & referral is obtained. The address is a basis by which RHD can properly assign the credit to the existing customer account. At this point, the company faces an obligation towards an existing customer and has presumably acquired a new customer. (2 marks) Measurement: Reliably measured at a fair value of $40 as supported by the marketing firm quote. (1 mark) Presentation & Disclosure: Presented as a marketing expense as a component of Selling expenses. The referral credit is not a sales discount nor an asset. The $40 cost is consistent with acquiring a new customer and would not reduce the gross profit margin. (2 marks) ii. Assume an existing customer earns a $40 referral credit. This happens after a successful purchase is made by a buddy referral. The existing customer subsequently purchases an item for $100 and redeems the $40 credit against their purchase. Prepare all journal entries associated with the program. (5 Marks) Upon valid referral: Debit: Marketing expense $40 (2 marks) Credit: Unearned revenue $40 Sale to existing customer: Debit: Cash $60 (3 marks) Debit: Unearned revenue $40 Credit: Sales revenue $ / 17

17 2. Young and Fit is a monthly magazine that has been operating for 18 months. It has a circulation of 1.4 million copies. The company wants to obtain a bank loan within the next 6 months to finance the cost of upgrading its facilities. To obtain the bank loan, Young and Fit needs to increase circulation to 1.6 million copies. To attract new customers, the company recently introduced the following pricing policy: New customers can order an annual subscription of the magazine for $18, which is three-quarters of the normal price. Payment of the annual subscription must be made when signing up to receive the magazine. Customers can cancel their subscription and get a full refund of the annual fee if they cancel within 30 days after receiving their first magazine. If customers do not cancel in the first month, they are bound to a one-year contract, that is, they cannot cancel later in the year and receive a partial refund. Although the offer of a full refund is risky, Young and Fit believes that few people will ask for a refund. Other companies have tried this type of promotion and have experienced great success. Their average cancellation rate was 20%. You are the controller of Young and Fit and one of your responsibilities is ensuring adequate financing is available to the company. The bank manager would like further information on the impact of the new pricing policy prior to approving the bank loan. Required: Write a brief memo to the bank manager indicating when revenue should be recognized for the magazines sold under this new pricing policy. State how each of the conditions for revenue recognition would be met as support for your recommendation. (5 Marks) Performance: Young & Fit will provide a magazine to its customers on a monthly basis. Once the company delivers the magazine to the customer, it has earned the monthly fee for the magazine. At that time, the customer enjoys the benefits of the magazine; managerial interest ceases at this point. Measurement: This aspect is where uncertainty and risk is faced by Young & Fit since recognizing revenue for the first month is dependent on its ability to estimate the number of customers who will ask for a refund of the annual fee. The experience of other companies may not be applicable to Young & Fit; as this is the very first time such a promotion is being run. No historical experience exists and the company cannot reasonably estimate the cancellation rate. If it would then it could recognize revenue of $1.50 for the first month and also set up an allowance for cancellation. As it cannot estimate the cancellation rate, then revenue should be recognized beginning in the second month, once it know (with certainty) the actual cancellation rate. Collectability: Young & Fit is certain of realizing the future economic benefits from the magazine subscription as cash is collected from the customers when the customer signs up for the magazine. There is uncertainty on how many customers will cancel their subscription and get a refund of the annual fee but this is a measurement uncertainty. Costs to earn revenue: The costs of producing and distributing the magazine will be incurred evenly throughout the year. These costs will be deferred in the first month and expensed beginning in the second monthly thereafter. This ensures proper matching in the same period as the revenue is recognized. ******** END OF EXAM******* 17 / 17