McGill University Desautels School of Management MGCR 211 INTRODUCTION TO FINANCIAL ACCOUNTING Winter 2014 Professor: Seda Oz

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1 McGill University Desautels School of Management MGCR 211 INTRODUCTION TO FINANCIAL ACCOUNTING Winter 2014 Professor: Seda Oz LAST NAME FIRST NAME STUDENT # FINAL EXAM Thursday - April 24, 2014 VERSION A 1. The exam is closed book, closed notes. Use of a calculator is permitted. The exam is to be completed individually. The McGill Code of Conduct is in effect. 2. You have 3 hours to complete the exam. Use your time wisely. 3. Read the questions carefully. Show all your work. GOOD LUCK! PART A. Multiple Choice: 30 pts PART B. Journal Entries: 8 pts PART C. Problems: 1. 6 pts pts 2. 8 pts 6. 8 pts pts 7. 7 pts 4. 5 pts 8. 8 pts PART D. Bonus: 5 pts FINAL SCORE: / 100 pts Seda Oz, 2014, All rights reserved Page 1 of 17

2 PART A: MULTIPLE CHOICE QUESTIONS Select the best answer for each of the following unrelated items (unless otherwise noted). Put your answers into scantron. Answers on the exam paper will not be marked. If more than one answer is given for an item than that item will not be marked. No partial credit. 1. Under the direct write-off method, the entry to record the estimated bad debts: A) is not done B) includes a credit to Allowance for Uncollectible Accounts C) includes a debit to Allowance for Uncollectible Accounts 2. Under the allowance method for estimating uncollectible accounts, the entry to write off an account: A) reduces total assets B) reduces net income C) has no effect on total assets D) increases net income 3. Using the aging-of-accounts-receivable method to estimate uncollectible receivables, CMU Corporation estimates that $3,750 of its accounts receivable will be uncollectible. Prior to adjustment, the Allowance for Uncollectible Accounts has a credit balance of $600. Bad debt expense to be reported on the income statement is: A) $4,350 B) $3,750 C) $3,150 D) $ Given the following data, calculate the cost of goods sold for the 11/15 sale using the weighted-average method for a perpetual inventory system, rounding to the nearest dollar. (Do not round in the process of your calculations, only round your final answer.) 1/1 Beginning inventory 50 units at $10 per unit 3/5 Purchases 30 units at $14 per unit 4/15 Sale 20 units at $30 per unit 5/30 Purchases 50 units at $15 per unit 11/15 Sale 60 units at $32 per unit 12/31 Ending inventory 50 units A) $720 B) $771 C) $785 D) $1,920 Seda Oz, 2014, All rights reserved Page 2 of 17

3 Answer: C Explanation: A) This would be correct using FIFO, not weighted average (30 $10) + (30 $14). B) This solution would be correct if the periodic inventory system were used. C) [(50 $10) + (30 $14) - (20 $11.50) + (50 $15)]/ = $785 D) This response incorrectly uses the sales price of the inventory to determine cost of goods sold, rather than the purchase price. 5. Which of the following statements is true? A) Depreciation is a process of objective valuation. B) Depreciation means that a business sets aside cash to replace assets as they become fully depreciated. C) Accumulated depreciation represents a growing amount of cash to be used to replace the existing asset. D) Accumulated depreciation is that portion of property, plant, and equipment's cost that has already been recorded as an expense. 6. At the end of an asset's useful life, the balance in Accumulated Depreciation will: A) be greater under units-of-production depreciation than under straight-line depreciation B) be the same amount under all the depreciation methods C) be a greater amount under straight-line depreciation than under double-decliningbalance depreciation D) be a lesser amount under double-declining-balance depreciation than under units-ofproduction depreciation 7. Lauter Tun Corporation acquired equipment on January 1, 2012, for $300,000. The equipment had an estimated useful life of 10 years and an estimated salvage value of $25,000. On January 1, 2015, Lauter Tun Corporation revised the total useful life of the equipment to 8 years and the estimated salvage value to be $10,000. Compute depreciation expense for the year ending December 31, 2015, if Lauter Tun Corporation uses straight-line depreciation. A) $25,938 B) $38,500 C) $41,500 D) $43, A revision of an estimate which extends the asset's useful life: A) is ignored until the last year of the asset's life B) requires restatement of prior years' financial statements C) increases depreciation expense and decreases owners' equity D) decreases depreciation expense and increases owners' equity Seda Oz, 2014, All rights reserved Page 3 of 17

4 9. Yeast Corporation purchased Bitter Ltd. on August 31, Yeast Corporation recorded goodwill in the purchase of Bitter. Yeast has determined that the Bitter goodwill will have an indefinite life. How will Yeast account for the Bitter goodwill in future accounting periods? A) Yeast will amortize the Bitter goodwill over a 50-year life. B) If the value of the Bitter goodwill increases in subsequent years, Yeast will increase the value in the Bitter Goodwill account. C) If the value of the Bitter goodwill decreases in subsequent years, Yeast will decrease the value in the Bitter Goodwill account. D) Yeast is not allowed to change the value of the Bitter Goodwill account regardless of any future increase or decrease in the value of Bitter Goodwill. 10. Following is the shareholders' equity section of the balance sheet of the Everslim Company: Share capital: Preferred shares, 420,000 shares authorized, 4,000 shares issued $400,000 Common shares, 100,000 shares authorized, 30,000 shares issued 150,000 Total share capital $550,000 Retained earnings 267,000 Total shareholders' equity $817,000 The preferred shares are currently selling for $ per share and the common shares are currently selling for $11.50 per share. The total share capital after the distribution of a $66,000 dividend is: A) $400,000 B) $150,000 C) $550,000 D) $817, On January 1, 2013, Agronomist Inc. had a balance of $340,000 in the long-term investments account. During 2013, Agronomist Inc. sold long-term investments for $115,000 cash, resulting in a $13,000 gain. On December 31, 2013, the long-term investments account showed a balance of $380,000. The long-term investments purchased during 2013 totalled: A) $75,000 B) $265,000 C) $155,000 D) $142,000 Seda Oz, 2014, All rights reserved Page 4 of 17

5 12. During 2013, Toxic Release LLC paid a total of $64,000 in cash for insurance. Toxic Release's Prepaid Insurance account had a balance on January 1, 2013, of $8,000 and a balance on December 31, 2013, of $5,500. The amount of Insurance Expense to be reported on Toxic Release's income statement for the year ended December 31, 2013, is: A) $58,500 B) $66,500 C) $64,000 D) $61, Geographic Enterprise's Inventory account decreased $37,500 and its Accounts Payable account (which relates solely to the purchase of merchandise) decreased $13,760 during the year. Geographic also reported sales of $856,000 and cost of goods sold of $597,600 during the same period. Geographic's payments to suppliers for inventory during the year were: A) $621,340 B) $573,860 C) $805,740 D) $648, Horizontal analysis involves the study of: A) percentage changes in a company's financial statements over a certain period of time B) percentage and/or dollar amount changes in various companies financial statement amounts from year to year C) the change in key financial statement ratios over a certain time frame or horizon D) the changes in individual financial statement amounts as a percentage of some related total 15. A very high accounts receivable turnover would most likely indicate that: A) net credit sales for the year have been understated B) policies for extending credit to customers are too tight C) accounts receivable balances have been overstated D) the company is unsuccessful in its efforts to collect cash from customers Seda Oz, 2014, All rights reserved Page 5 of 17

6 16. Which, if any, of the following events would result in the recording of a contingent liability for Rothko, Inc.? A) Rothko is being sued by Guston, Co. and legal counsel estimates that it is reasonably possible that Rothko will have to pay $15 million to settle B) Rothko is named as one of the defendants in a class action suit and legal counsel estimates that it is probable that Rothko will have to pay $12 million to settle C) Rothko sues Bontecou, LLP for patent infringement and legal counsel estimates that it is probable that Rothko will receive $7 million in a settlement D) Rothko is being sued by Close Corp. Legal counsel has deemed this a frivolous lawsuit, certain to be dismissed by the courts. 17. Which of the following activities increase and decrease the non-current assets available to a company? A) operating activities B) investing activities C) financing activities D) warehousing activities 18. A company s income statement for the year ended December 31, 2012 showed a net profit of $83,600. Before releasing the financials the auditor found that $18,000 paid for the purchase of a truck had been debited in error to the repairs expense account. It is the company s policy to depreciate trucks at 25% per year on the straight line basis, with a full year s charge in the year of acquisition. What would the net profit be after adjusting for this error? A) $106,100 B) $70,100 C) $97,100 D) $101, Which of the following statements is/are correct? (1) From among inventory cost flow assumptions, FIFO always produces the highest reported net income figure (2) From among inventory cost flow assumptions, FIFO always produces the lowest reported net income figure (3) LIFO is prohibited as a cost flow assumption under IFRS (4) LIFO is permitted as a cost flow assumption under IFRS if it produces the lowest profit measure A) 1 and 4 B) 3 only C) 1 and 3 D) 2 and 3 Seda Oz, 2014, All rights reserved Page 6 of 17

7 20. Assets that produce their greatest benefits to a firm early in their useful life should be depreciated using the: A) straight-line method. B) declining-balance method. C) compound interest method. D) units-of-activity method. 21. Venus Ltd. secured a $750,000, five year, 8% note payable on January 1. The loan will be repaid using blended monthly payments with a fixed monthly principal payment of $12,500. Which of the following represents how the loan will be reflected on the balance sheet at the end of the first year? A) Long term Liabilities note payable: $750,000 B) Current portion of long term debt: $150,000, Long term liabilities note payable: $450,000 C) Current portion of long term debt: $300,000, Long term liabilities note payable $ 450,000 D) Current portion of long term debt: $600, What is the effect of classifying a lease as an operating lease, as opposed to as a finance lease, on the debt to equity ratio and times-interest-earned ratio? Debt to equity ratio Times-interest-earned ratio A) Overstated Overstated B) Overstated Understated C) Understated Overstated D) Understated Understated 23. The type of preferred share that can be bought back by the company at a specified time and price is a: A) cumulative preferred share. B) convertible preferred share. C) redeemable preferred share. D) nonparticipating preferred share. Seda Oz, 2014, All rights reserved Page 7 of 17

8 Use the following information for questions 24 25: Streetside Construction agreed to build a shopping centre for a total revenue of $30,000,000 over the next four years. Estimated cost for years one through four are: $7,500,000; $5,000,000; $5,000,000; and $2,500, Estimated profit or loss for year one, assuming the percentage of completion method, would be: A) $(2,500,000) B) $0 C) $3,750,000 D) $2,500, Streetside Construction decided to complete construction in 3 years. However, cutting back 1 year in construction schedule means an increase in total estimated costs. Assume that at beginning of year 3 total estimated costs to complete the job in three years were revised to $35,000,000. Under the percentage of completion method, the loss for year three would be: A) $(6,250,000) B) $(11,250,000) C) $(5,000,000) D) $(7,000,000) Seda Oz, 2014, All rights reserved Page 8 of 17

9 PART B: JOURNAL ENTRIES Record the correct journal entry for each of the following unrelated transactions (unless otherwise noted). Put your answers directly on your examination paper. Please be careful as there is little room for partial credit. 1. Smart-T has just signed up for a BK Trust debit card machine (interact) which charges a 1% fee. On March 15th Smart-T has debit card transactions totaling $15,550. Record the journal entry for this day's sales. Answer: March 15 Cash $15, Interact Fee Sales Revenue $15, Key West Corporation, a public company determined its plant has experience an impairment due to a loss in market value. The impairment amount calculated by the controller totals $22,650. Prepare the required journal entry. Answer: Dr. Loss on Impairment $22,650 Cr. Accumulated Depreciation - Plant $22, Glenmore Reservoir Corporation paid $4,000,000 in a lump-sum purchase of land, a building, and equipment. The payment consisted of $1,500,000 cash and a note payable for the balance. An appraisal indicated the following fair values at the time of the purchase: Land $ 1,600,000 Building 2,500,000 Equipment 500,000 Prepare the journal entry to record this lump-sum purchase (round all percentage calculations to two decimal places). Answer: Asset FV Total FV % Cost Allocated cost Land 1.6M 4.6M 35% 4.0M $1.4M Building % Equipment % DR. Land 1,400,000 DR. Building 2,160,000 DR. Equipment 440,000 CR. Cash 1,500,000 Seda Oz, 2014, All rights reserved Page 9 of 17

10 CR. Note Payable 2,500, Terrain Corporation sold office equipment for $10,000 cash. The original cost of the equipment was $15,000; accumulated depreciation up to the date of sale had a balance of $6,900. Record the necessary journal entry. Answer: Cash 10,000 Accumulated Depreciation-Office Equipment 6,900 Office Equipment 15,000 Gain on Sale of Office Equipment 1,900 Seda Oz, 2014, All rights reserved Page 10 of 17

11 PART C: PROBLEMS There are 7 unrelated problems in this section. Put your answers directly on your examination paper. If you need extra space you may use back side of your exam s pages. 1. Determine the effect on cost of goods sold, total assets, and gross margin for 2013 and 2014 if the following inventory errors are not corrected. Indicate your answer with (+) for overstated, (-) for understated, and (0) for no effect. a. Beginning inventory for 2013 is understated 2 POINTS b. Ending inventory for 2013 is overstated 2 POINTS Effect in 2013 on Cost of Goods Sold Total Assets Gross Margin a. b. Effect in 2014 on Cost of Goods Sold Total Assets Gross Margin a. b. Answer: Effect in 2013 on Cost of Goods Sold Total Assets Gross Margin a b Effect in 2014 on Cost of Goods Sold Total Assets Gross Margin a b Seda Oz, 2014, All rights reserved Page 11 of 17

12 2. Cough FX Limited reports the following shareholders' equity as of December 31, 2013: Preferred shares, $5.00, authorized 100,000 shares, issued 80,000 shares $4,400,000 Common shares, authorized 200,000 shares, issued 150,000 shares, 146,000 outstanding 2,190,000 Retained earnings 3,400,000 $9,990,000 Determine the following: a. What was the average issue price per common share? b. What was the average issue price per preferred share? c. Assume the board of directors authorizes a 2-for-1 split on the common shares. Calculate the number of shares outstanding after the split and the book value of both classes of shares. d. Assume the board of directors authorizes a 15% stock dividend on the common shares after the stock split. The current selling price of the common shares is $9. Prepare the journal entry to distribute the stock dividend. Answer: a. ($2,190,000) / 146,000 = $15 b. ($4,400,000) / 80,000 = $55 c. 146,000 2 = 292,000 shares outstanding Preferred shares: $55.00 Common shares: $9,990,000 - $4,400,000 = $5,590,000; $5,590,000 / 292,000 = $19.14 d. DR. Dividends 394,200 (292, $9) CR. Common shares 394,200 (292, $9) 3. Nitrogen Inc. had the following events occur in Calculate the cash receipts or cash disbursements for each event. a. Taxes Payable on January 1 was $12,400 and on December 31 was $13,600. Income Tax Expense on the income statement was reported at $39,000. b. Cost of goods sold on the income statement was reported at $50,000. Accounts Payable increased $5,000 and Inventory decreased $7,000. c. Sales were reported on the income statement at $100,000. Accounts Receivable increased $5,700. d. Interest Revenue on the income statement was reported at $12,000. Interest Receivable decreased $3,600. Seda Oz, 2014, All rights reserved Page 12 of 17

13 e. Salary Expense on the income statement was reported at $55,000. Salary Payable increased $3,900. Answer: a. $12,400 + $39,000 - $13,600 = $37,800 b. $50,000 - $7,000 - $5,000 = $38,000 c. $100,000 - $5,700 = $94,300 d. $12,000 + $3,600 = $15,600 e. $55,000 - $3,900 = $51, Below is the cash flow statement for Optical Operations Inc. They have just finished their second year of operation and have approached you, the manager of the local branch of The Canadian Bank, to ask for a loan. Required: a. Do you think Optical Operations Inc. has had a successful year? Support your answer. b. Discuss 1 (ONE) weakness of this company based on its cash flow statement? c. Are there any conditions you would require before you granted them a loan? Optical Operations Inc. Cash Flow Statement Indirect Approach For the Year Ended December 31, 2011 Cash flows from operating activities: Net income $ 45,000 Add: Amortization 24,500 Less: Increase in accounts receivable (18,000) Increase in inventory (71,000) Increase in prepaid expenses (5,500) Decrease in accounts payable (4,600) Cash provided by operating activities $(29,600) Cash flows from investing activities: Proceeds from sale of temporary investments 12,000 Purchase of equipment (95,000) Cash used by investing activities (83,000) Cash flows from financing activities: Proceeds from issue of common shares 75,000 Payment of cash dividends (25,500) Cash provided by financing activities 49,500 Decrease in cash (63,100) Cash balance, January 1, ,000 Cash balance, December 31, 2011 $(5,100) Seda Oz, 2014, All rights reserved Page 13 of 17

14 Solution: a. The company had a positive net income in their second year, which is very good. (Startup companies might not show a profit for several years.) However, their cash flow from operations and overall change in cash for the year are both negative. They appear to be growing as they invested in equipment and have increased the amount of inventory on hand, but perhaps they are growing too fast or are undercapitalized (although they sold more shares this year). Both of those issues can lead to cash flow problems. It is difficult to completely evaluate their performance without the income statement. b. The increase in inventory, accounts receivable and prepaids are all consistent with a growing company, however the increase in inventory is much larger than the increase in accounts receivable and I wonder about their inventory management. Do they have too much inventory on hand? Are there any obsolete items? The decrease in accounts payable is also a concern given the increase in inventory. Are they paying their accounts more (or too) quickly? Perhaps they would not be in such a tight situation for cash if they could stretch them out more or it the payables had grown on a basis consistent with the inventory or accounts receivable. Another concern is the high level of dividends paid in a relatively new company. They paid out a significant portion of net income as dividends. Are the owners taking out too much money from the company and could they leave more of it invested in the company to help finance the growth? c. The other information I would like would be the comparative income statements and balance sheets and more information about the level of inventory. I would also want to confirm their credit policies and accounts payable terms to see if they are making the best use of the cash available from those sources. I would also like to know what assets are available for collateral for the loan. I would want restrictions on future dividend payments before I granted them a loan and some form of collateral. Seda Oz, 2014, All rights reserved Page 14 of 17

15 April 24, 2014 Introduction to Financial Accounting - Final (Version: A) Answer Key 5. Listed below are the various types of activities or transactions reported on the cash flow statement, followed by a series of transactions. Match each transaction to its related activity AND indicate the cash impact for each transaction. Abbreviations: O = Operating activity I = Investing activity INFLOW = Cash inflow F = Financing activity N = Non-cash transaction OUTFLOW = Cash Outflow ACTIVITY CASH IMPACT Collection of cash dividends O + Collection from customers O + Proceeds from sale of patent I + Payment of interest O - Purchase of land with common shares N N Prepayment of insurance policy O - Purchase of equipment I - Declaration of a dividend payment N N 6. a. Explain how it would be possible for a company to report a positive net income on the income statement but a net cash outflow in cash from operations on the cash flow statement. Be specific and give at least one example to support your answer. b. Does the cash outflow in operations indicate that the company is in trouble? Solution: The income statement is prepared on the accrual basis and it may be possible for a company to report a net income but have a negative cash from operations. This would arise if a company had incurred costs and paid for them, but not yet expensed them; for example prepaid insurance or items still in inventory. Alternatively, they could be reporting sales but not have collected all of the cash yet, thus the revenue (and hence income) would increase but not the cash from operations. Paying off current liabilities would also reduce the cash from operations but not be reflected on the income statement. Page 15 of 17

16 April 24, 2014 Introduction to Financial Accounting - Final (Version: A) Answer Key The cash outflow in operations does not necessarily mean the company is in trouble. It is not uncommon for companies to have a negative cash from operations while they are getting established or growing. In a more mature company it might be a sign of trouble because in the long-run cash from operations should be positive to support the financing and investing activities of the company. 7. The following has been extracted from a Complaint filed against a corporation by the Securities and Exchange Corporation in the United States. This case involves chronic fraudulent conduct - including financial reporting fraud and other intentional public misrepresentations - by Biovail Corporation, a Canadian pharmaceutical company whose common stock is traded on the New York and Toronto stock exchanges. The following transaction is alleged to have been improper: Transaction: A new entity, Pharmaceutical Technologies Corp. (known as Pharmatech), was founded by a party unrelated to Biovail. Biovail transferred to this company its R&D activities related to a new Drug. Despite the fact that research and development costs were expected to be in the tens of millions of dollars for this new drug, with some estimates as high as $120 million, Pharmatech's sole shareholder, whom Biovail secured (endorsed the loan at the Bank), invested only $1 million in the company, of which $350,000 was immediately refundable as a fee. Biovail secured financing for Pharmatech from its own lender (the"bank"), based on Biovail s CEO assurances that, if at any time the Bank chose not to renew the Pharmatech financing, Biovail would purchase Pharmatech and retire the debt. Pharmatech signed an agreement with Biovail such that Biovail would receive the benefits related to any of Pharmatech research that is successful. If a new drug is discovered, Pharmatech would be refunded the entire cost of its research, plus a small fee. Required: a. Describe the impact on the financial statements of Biovail from the manipulation involved in this transaction? b. What seems to have been the reporting objectives of the management of Biovail in entering in this manipulation? Solution: a. It seems pretty clear that the risk and rewards of these activities have not been transferred to Pharmatech If it works, Biovail gets the benefits, and if it does not work, they will suffer the cost (buy back the company, and pay back the debt) obviously, these transactions should have been in Biovail (1 mark) R&D should have been in Biovail, and Expensed Net income for Biovail appears Page 16 of 17

17 April 24, 2014 Introduction to Financial Accounting - Final (Version: A) Answer Key HIGHER than should be (2 marks) Debt should have been in Biovail Debt of Biovail appears lower than it should be (2 marks) Cash Flow from Operating Activities is higher as R&D expenditures flow thru Pharmatech; Cash flow from Financing Activities is lower as debt proceeds are received via Pharmatech. Later, if Pharmatech is bought out by Biovail, the Investing Activities would show a decrease in Cash Flows. (2 marks) b. Biovail seems to have been struggling to meet an earnings forecasts, given the text, and to meet it, they seem to have needed to increase net income (2 marks) OR Income maximisation is also accepted as a valid answer (2 marks) As the transaction above led to off balance sheet financing, this seems to also be a valid motivation (OFF-BALANCE-SHEET DEBT) (2 marks) Page 17 of 17