Exam 1 Acct 414 Corporate Accounting & Reporting II Spring 2011

Transcription

1 Exam # Name: Exam 1 Acct 414 Corporate Accounting & Reporting II Spring 2011 Show any necessary computations if you want to be eligible for partial credit. Present your work in a neat, well-organized manner. When you are using a financial calculator, spell out what you put in for n, i, PMT, FV, PV, etc. You could also draw a time-line if that would explain your thinking to me. You may use abbreviations in your essay answers but I need complete thoughts. Follow the instructions and answer all parts of the question as directed Time Value of Money (45 points total) 4. Loan Impairment (30 points total) 5 Leases (70 points total) IFRS points (5b, 5c & 5d) US GAAP points (5a & 5e) 6. Fair value & fair value option (30 points) 7. Serial Bonds (25 points) Total points earned (max = 200) To be completed by professor: After Exam 1 - Course Grade Total Points = /500 = % Quiz and HW percentage = Projects percentage = % %

2 Exam 1 Acct 414 Spring 2011 Page 2 1. On October 31, 2010, Franny Farms Inc. purchased a machine for $500,000. The down payment was $25,000, and the balance will be paid in 48 equal monthly payments, including interest at 12% per annum compounded monthly. What is the amount of the monthly payment if the first payment is due November 30, 2010? The monthly payment would be $ 2. Percy Corporation wants to accumulate $1,000,000 on December 31, 2020 to retire preferred stock. The company plans to deposit $250,000 in a savings account on January 1, 2012 which will earn interest at 8% compounded quarterly for nine years (until 12/31/20). Percy Corporation will begin making equal quarterly deposits on December 31, 2012 and will continue making quarterly deposits until December 31, The controller wants you to compute the amount of the quarterly deposits that will, with the initial deposit, accumulate to the necessary $1,000,000. You may assume that the account will continue to pay the same interest rate (8% compounded quarterly). [15 points] REQUIRED: What is the amount of the necessary quarterly deposits? $

3 Exam 1 Acct 414 Spring 2011 Page 3 3. Assume that you are working for a leasing company. The original lease agreement specified an annual payment of $35,000 over a six-year lease term. The first payment was to be made immediately and the asset was to be returned to the lessor at lease end. These terms gave a healthy return to the leasing company. However, the lessee wants to be able to buy the asset for $15,000 at the end of the lease (when the estimated fair value will be $40,000). Since the fair value of the asset was approximately $181,400, the original rate of return was about 12%. You boss wants you to compute the new rate of return to be sure it is adequate. Find the interest rate implicit in the lease assuming the terms are modified to include a purchase option for $15,000 at the end of 6 years. Carry computation to two decimal places. The implicit rate is % Extra credit: If the lessor agrees to the bargain purchase option but still wants to earn 12%, what lease payment would be needed (instead of the $35,000 in the proposed lease agreement)? (5 points)

4 Exam 1 Acct 414 Spring 2011 Page 4 4. Troubled debt restructuring. [20 points] On March 1, 2011, a debtor owes $500,000 plus $60,000 in accrued interest on a note payable. The original interest rate on the loan was 12%. The debtor is unable to make any payments toward principal or interest at this time. The creditor agrees to modify the terms of the agreement as follows: (1) The total amount due is reduced to $400,000. (2) The interest rate on the debt will be lowered to 10%. (3) The term of the restructured debt is four years with interest only due during the first three years. Principal and interest will be due at the end of the fourth year. Instructions Show any entries needed on the books of the creditor at the following dates note the variations in revenue recognition methods shown by each date. You will need to compute the creditor s LOSS from this troubled debt restructuring. March 1, 2011, Date of restructuring (assuming the creditor uses the effective interest method to recognize revenue) December 31, 2011, end of fiscal year (assuming the creditor uses the effective interest method to recognize revenue) December 31, 2011, end of fiscal year (assuming the creditor uses the cost recovery method to recognize revenue)

5 Exam 1 Acct 414 Spring 2011 Page 5 5. Lease Accounting. On February 1, 2011, Jem Jewelers (lessee) and Frederic Fixtures Corp. (lessor) signed a lease with the following terms: 1. Term: 7 years 2. Annual payments of $36, Implicit interest rate (not known to lessee) 10% 4. Cost of asset $180,000 (not known to lessee) 5. Fair value of asset $210, First payment due upon signing 7. Incremental borrowing rate: 12% 8. There are no cost uncertainties for lessor 9. Estimated useful life of asset: 10 years 10. The residual value is NOT guaranteed by lessee 11. Est. fair value of asset at end of lease: $25, The lessor is concerned about collectability of payments 13. A commission of 1% of the fair value of the leased asset is 14. Lessor and lessee both use straight-line depreciation for paid to the salesperson who negotiated the lease. 15. There is a purchase option for $25,000 at the end of the lease. If the purchase option is not exercised, the asset is returned to the lessor at the end of the lease. fixed assets and have fiscal years that end on December The lessee is responsible for loss from fire or other casualties, all property taxes and maintaining the equipment. The estimated total cost to the lessee is $2,000 per year. a. Classify the lease under US GAAP for both the lessor and the lessee. Explain. Let me know that YOU know all the rules. Abbreviations are fine as long as they are obvious. If you do present value computations, be sure to provide the inputs. [15 points] LESSEE = LESSOR = b. Classify the lease under International Financial Reporting Standards (IFRS) for both the lessor and lessee. If your answer is different than it would be under US GAAP, discuss why the answer is different. Again, let me know that you know the IFRS criteria. Abbreviations are fine [10 points]

6 Exam 1 Acct 414 Spring 2011 Page 6 Problem 5 (continued) Repeat of facts: On February 1, 2011, Jem Jewelers (lessee) and Frederic Fixtures Corp. (lessor) signed a lease with the following terms: 1. Term: 7 years 2. Annual payments of $36, Implicit interest rate (not known to lessee) 10% 4. Cost of asset $180,000 (not known to lessee) 5. Fair value of asset $210, First payment due upon signing 7. Incremental borrowing rate: 12% 8. There are no cost uncertainties for lessor 9. Estimated useful life of asset: 10 years 10. The residual value is NOT guaranteed by lessee 11. Est. fair value of asset at end of lease: $25, The lessor is concerned about collectability of payments 13. A commission of 1% of the fair value of the leased asset is 14. Lessor and lessee both use straight-line depreciation for paid to the salesperson who negotiated the lease. 15. There is a purchase option for $25,000 at the end of the lease. If the purchase option is not exercised, the asset is returned to the lessor at the end of the lease. fixed assets and have fiscal years that end on December The lessee is responsible for loss from fire or other casualties, all property taxes and maintaining the equipment. The estimated total cost to the lessee is $2,000 per year. c. Regardless of your answer to part b, assume that Jem Jewelers (the lessee) follows IFRS and classifies the lease as a finance lease. Prepare the appropriate amortization table for the first two payments (10 points). Date Payment Interest Principal Portion Balance 0 2/1/11 1 2/1/12 d. Regardless of your answer to (b), assume that (under IFRS) the lease is a finance lease for Jem Jewelers. Provide the necessary journal entries to record the transactions for Jem Jewelers (the lessee) at February 1, 2011 and December 31, 2011 (15 points) 2/1/11 under IFRS LESSEE 12/31/11

7 Exam 1 Acct 414 Spring 2011 Page 7 Problem 5 (continued) Repeat of facts: On February 1, 2011, Jem Jewelers (lessee) and Frederic Fixtures Corp. (lessor) signed a lease with the following terms: 1. Term: 7 years 2. Annual payments of $36, Implicit interest rate (not known to lessee) 10% 4. Cost of asset $180,000 (not known to lessee) 5. Fair value of asset $210, First payment due upon signing 7. Incremental borrowing rate: 12% 8. There are no cost uncertainties for lessor 9. Estimated useful life of asset: 10 years 10. The residual value is NOT guaranteed by lessee 11. Est. fair value of asset at end of lease: $25, The lessor is concerned about collectability of payments 13. A commission of 1% of the fair value of the leased asset is 14. Lessor and lessee both use straight-line depreciation for paid to the salesperson who negotiated the lease. 15. There is a purchase option for $25,000 at the end of the lease. If the purchase option is not exercised, the asset is returned to the lessor at the end of the lease. fixed assets and have fiscal years that end on December The lessee is responsible for loss from fire or other casualties, all property taxes and maintaining the equipment. The estimated total cost to the lessee is $2,000 per year. e. Regardless of your answer to part a, assume that the lessor has a sales-type lease under US GAAP. Prepare any journal entries that would be required at the dates listed. Completion of the amortization table is optional but possibly helpful. [20 points] Lessor s amortization table: Date Payment Interest Principal Portion Balance 0 2/1/11 1 2/1/12 2/1/11 US GAAP for LESSOR 12/31/11 (end of fiscal year)

8 Exam 1 Acct 414 Spring 2011 Page 8 6. Fair Value Option. Dallas Inc. has one asset, a bond issued by Ft Worth Company that Dallas Inc. purchased at face value as an investment (accounted for at fair value as trading security). Dallas Inc. has only one liability, a bond that was issued at face value to finance the purchase of the Ft. Worth Company bond. There is no initial shareholder investment. Terms of the bonds Ft. Worth Company Bond Investment Dallas Inc. Bond Payable Face value 10,000,000 10,000,000 Coupon rate (annual) 10% 8% Term (in years) Semiannual interest payment 500, ,000 Yield rate at year end (simple interest) 11.00% 9.00% a. Prepare a balance sheet for Dallas Inc. at the END of the first year assuming that the fair value option was selected for the bond payable. Assets Liabilities & Owners Equity Cash Bond Investment Bonds payable Owner s equity Total Total b. Prepare a balance sheet for Dallas Inc. at the END of the first year assuming that the fair value option was not selected for the bond payable. Assets Liabilities & Owners Equity Cash Bond Investment Bonds payable Owner s equity Total Total Extra credit (2 points): What type of measurement is being used to find the fair values? Circle one: Level 1 Level 2 Level 3

9 Exam 1 Acct 414 Spring 2011 Page 9 7. Serial Bonds [20 points] On April 1, 2011, Deer Lodge Corporation issued $6,000,000 in serial bonds. The bond principal will be repaid in $1,500,000 increments beginning on April 1, 2012 with the final payment to be made on April 1, The bonds pay interest semi-annually on October 1 and April 1. The coupon rate is 10% per annum. An investment banker handled the transaction and you have just received a check for $ 6,331,142. This is a yield rate of 7.5% per annum. You do NOT need to prepare amortization tables. Required: (a) Using the effective interest method, prepare the journal entry needed at October 1, 2011 when the first payment of interest is made to the bondholders. (b) Using the bonds outstanding method, what fraction would you use as part of the computation of interest expense related to the interest payment on October 1, 2011? What amount of interest expense would be recognized? Fraction =, Interest expense = $

10 Exam 1 Acct 414 Spring 2011 Page 10 SOLUTIONS Problem 1, find loan payment Annual rate= Problem 3 - implicit rate in lease n= 48 12% pmt 35, i= 1.00% pmts are monthly Number of payments 6 annual PMT= Future value (residual) 15,000 BPO pv= (475,000) Selling price less pv= $ (181,400) fv - down payment ordinary=0; due=1 1 ordinary annuity=0;annuity due=1 0 solve for implicit rate 8.675% per year Solve for pmt $12, Problem 3 - extra credit Problem 2 deferred annuity - accumulation of sinking fund n= 6 annual n= (quarters) 3 Step 1 find FV i= 12% per yr i= 2.00% per quarter pv= (181,400.00) PMT= - fv= 15, BPO pv= (250,000) Deposit 1/1/12 ordinary annuity = 0; annuity due = 1 1 fv= - Solve for payment = 37, ordinary annuity=0;annuity due=1 0 grows to 4. Troubled debt Solve for FV 265, on Oct 1, 2012 n= 4 years PV=FV 265, i= 12% original rate n= yrs * 4/yr - 3 qtrs pmt (using new rate)= (40,000.00) 10% FV= (1,000,000.00) needed 12/31/20 fv= (400,000.00) i= 2% ordinary annuity = 0; annuity due = 1 0 PMT=???? Solve for present value = $375, type= 0.00 Carrying value = 560, Solve for PMT 10, Quarterly deposit Loss= (184,298.79) Problem 4 journal entries: See above table for present value computations. The creditor always finds the present value of the revised cash flows using the original interest rate (both US GAAP and IFRS). In this problem, there is no initial payment. The loss is the difference between the present value of the future cash flows ($375,701) and the carrying value ($560,000). Under the effective interest method, interest revenue is $375,701 * 12% * 10/12 = 35,570. Under the cost recovery method, no entry is needed at 12/31/11 since we do not accrue principal. Creditor journal entries Debit Credit 3/1/2011 Cash 0 Restructured note receivable 375,701 Loss on loan impairment 184,299 Accrued interest receivable 60,000 Note receivable (old) 500,000 12/31/2011 Effective interest method: Interest receivable 35,570 Interest revenue 35,570 12/31/2010 Cost recovery method = no entry - 5a. Lease classification under US GAAP LESSEE. Under US GAAP, this would probably be an operating lease for the lessee. Lessee fails all 4 tests (although it is very close to passing the PVMLP test): No TT, no BPO, LT <75% and the PVMLP using the 12% incremental borrowing rate is 188,192 = 89.6% of FMV. {n=7, i=12%, pmt=36818, fv=0, type=begin}. Alternately: PVMLP must be greater than or equal to 90% * 210,000 = 189,000.

11 Exam 1 Acct 414 Spring 2011 Page 11 Note that the executory costs are irrelevant since they will not be paid by the lessor and initial direct costs do not affect the classification of the lease. LESSOR under US GAAP: Since the lessor uses the 10% implicit rate, the lessor meets the 90% of FMV rule [$197,170 = 94% of $210,000 FMV]. However, the lessor has collectability concerns. Therefore, it cannot classify this lease as a sales-type lease even though there is a profit. Again, the executory costs are not relevant because the de facto owner is the lessee and the lessee will pay these costs directly. The initial direct costs would be amortized straight-line over the lease term because it is an operating lease. 5b There are 5 indicators under IFRS. This does not appear to be specialized equipment and there is no title transfer or bargain purchase option. The lease term is 70% of economic life (which could be considered a major part of the economic life). Under IFRS, the lessee is supposed to use the implicit rate if it is practicable to determine. This would make the present value of the minimum lease payments is $197,170 (see lessor above) [n=10, i=10%, pmt=36,818, fv=0, type=begin] which is 94% of the estimated fair market value. Therefore, the PVMLP seems to amount to at least substantially all the fair value of the leased asset (even if the lessee uses its 12% incremental borrowing rate). Accordingly, this would be classified as a finance lease for the lessee. For lessor, it is also a finance lease since the PVMLP is substantially all of the $210,000 estimated fair value ($197,170 using the 10% implicit rate). The lease term is also a major part of the economic life at 70%. There are no extra lessor rules under IFRS. The initial direct costs would be expensed immediately since this lessor is a manufacturer or dealer and has a profit. As stated in instructions, I was looking for answers that told me that you knew the 5 IFRS guidelines (not bright-line rules) and the 4 US GAAP rules for lessees plus the extra rules for lessors, I also wanted you to know that under IFRS, lessees use the implicit rate if practicable to determine, and that IFRS does not have the collectability and performance completion extra rules that we have for lessors under US GAAP. I also needed the details for the present value computations and you lost points if you did not compute them correctly. Common mistake = including the unguaranteed residual value in the PVMLP computations. A FORMAT FOR A GOOD ANSWER TO THE ESSAY QUESTIONS Lessee = Operating. TT = no LT =70% [ 75%] BPO = no PVMLP = $188,192 = 89.6% 90% of fair value n=7 i=12% pmt=36,818 fv=0 and begin [or type=1] Therefore, the lease fails all 4 tests which makes it an operating lease. Lessor = Operating. TT=no, BPO = no, LT=70%, PVMLP = 197,170 =94% of fair value n=7 i=10% annuity due [or type=1] pmt=36,818 fv=0 So the lessor passes ONE of the first 4 tests. There are 2 additional lessor-only tests that must be met. Although costs are determinable, the collection is uncertain so this cannot be a sales-type lease Problem 5c - Amortization table for lessee was required but based on IFRS, it would use the implicit rate of 10%, not the incremental borrowing rate and therefore begin with the PVMLP computed earlier for the lessor: Date Lease Payment Interest Principal Balance 02/01/11 10% 197, /01/11 36, , , /01/12 36,818 16,035 20, , /01/13 36,818 13,957 22, , /01/14 36,818 11,671 25,147 91, /01/15 36,818 9,156 27,662 63, /01/16 36,818 6,390 30,428 33, /01/17 36,818 3,347 33,471 0

12 Exam 1 Acct 414 Spring 2011 Page 12 5d Lessee journal entries, finance lease assumption (IFRS) Lessee journal entries FINANCE LEASE Jem Jewelers debit credit 02/01/11 Equipment (using 10% implicit) 197,171 Lease liability 160,353 Cash 36,818 total 197, ,171 Prorated: % 12/31/11 Interest expense 14,699 Interest payable 14,699 7 life Depreciation expense 25,820 $ 28, Accumulated depreciation expense 25,820 Life = lease term because no TT or BPO Interest expense can be computed: 160,353 * 10% * 11/12 5e Amortization Table for Lessor starts with FMV (since this is a sales type lease). The table was optional Lease Reduction LEASE Date Payment Interest in lease Receivable 210, % receivable BALANCE 02/01/11 210, /01/11 36, , , /01/12 36, , , , /01/13 36, , , , /01/14 36, , , , /01/15 36, , , , /01/16 36, , , , /01/17 36, , , , /01/18 25, , , e lessor journal entries assuming sales-type lease (I suggest plugging the COGS amount but it can also be computed as 180,000 the PV of the 25,000 unguaranteed residual value of 12,829) LESSOR Frederic Fixtures debit credit Spring 2011 US GAAP sales type lease same JEs as under IFRS 02/01/11 Net Investment in Lease (FMV - first pymt) 173,182 Sales PVMLP 197,170 Cost of goods sold Cost - PV of UNGRV 167,170 Inventory given 180,000 Cash 36,818 Initial direct costs 2,100 Cash, commissions payable, etc. 2,100 total 379, , months Prorated: /31/11 Interest Receivable 15,875 Interest Revenue (173,182*10%*11/12) 15,875

13 Exam 1 Acct 414 Spring 2011 Page 13 Problem 6 Fair Value Option (FASB 159) Bond payable at fair a. Fair value option is adopted value Liabilities & Owners Assets Equity Cash 200,000 Bonds payable 9,097,500 Bond Investment 9,160,490 Owner s equity 262,989 Total 9,360,490 Total 9,360,490 b. Fair value option is NOT adopted Bond payable at face value Liabilities & Owners Assets Equity Cash 200,000 Bonds payable 10,000,000 Bond Investment 9,160,490 Owner s equity -639,510 Total 9,360,490 Total 9,360,490 Supporting computations for problem 6: Principal (FV) $ 10,000,000 $ 10,000,000 Yield rate 5.50% 4.500% Number of payments PMT= 500, ,000 ordinary=0; due=1 0 0 Solve for PV $9,160, $9,097, Beginning cash balance 0 Interest revenue 1,000,000 Interest expense -800,000 Ending cash 200,000 Income statements a. Fair value option b. Fair value option (not required) ADOPTED NOT adopted Interest revenue 1,000,000 1,000,000 Interest expense -800, ,000 Gain/loss on bond investment -839, ,510 Gain/loss on bond payable 902,500 0 Net income 262, ,510 #7 Serial bonds. 7a Interest expense using effective interest method = carrying value times yield rate for 6 months so $6,331,142 * 3.725% = 237,418 10/1/2011 journal entry: Interest expense (6,331,142 * 7.5%/2) 237,418 Premium on bonds payable (plug) 62,582 Cash (6,000,000 * 5%) 300,000 Common error: not reading the question. Some students gave me the 4/1/11 entry instead of the one I asked for!

14 Exam 1 Acct 414 Spring 2011 Page 14 Problem 7, continued Amortization table was NOT required but I ve pasted it below. The effective rate is only approximate so it does not come out right at the bottom. The actual effective rate was %. Note that the bonds outstanding method table comes out fine. EFFECTIVE INTEREST AMORTIZATION SCHEDULE 5.00% 3.750% Face Value: 6,000,000 Period Date Interest Principal Interest Amorti- Carrying BALANCE FACE Paid Payment Expense zation Value PREMIUM VALUE 0 04/01/ ,331, ,142 6,000, /01/11 300, ,418 62,582 6,268, ,560 6,000, /01/12 300,000 1,500, ,071 64,929 4,703, ,631 4,500, /01/12 225, ,386 48,614 4,655, ,017 4,500, /01/13 225,000 1,500, ,563 50,437 3,104, ,580 3,000, /01/13 150, ,422 33,578 3,071,002 71,002 3,000, /01/14 150,000 1,500, ,163 34,837 1,536,164 36,164 1,500, /01/14 75,000 57,606 17,394 1,518,771 18,771 1,500, /01/15 75,000 1,500,000 56,954 18, b For the fraction used in bonds outstanding method, just count up the face values outstanding: 6M + 6M + 4.5M + 4.5M + 3M + 3M + 1.5M + 1.5M= $30 million total. So the discount/premium will be amortized with a 6/30 fraction for the first 2 interest payments. Since this bond was issued at a premium, the amortization of the premium DECREASES interest expense (as compared to interest paid). Interest expense for the first 6 months would therefore be: Amount paid = $6,000,000 * 5% coupon rate = $300,000 MINUS (6/30 * $331,142 premium) = 236,071 Journal entry and table were NOT required 10/1/2011 journal entry: Interest expense (plug) 236,071 Premium on bonds payable (6/30 * 331,142) 63,929 Cash (6,000,000 face * 5% coupon rate) 300,000 Bonds Outstanding Method 5.00% Face Value: 6,000,000 Period Date Interest Principal Interest Amorti- Carrying BALANCE FACE Amortization Paid Payment Expense zation Value PREMIUM VALUE Fraction 0 04/01/ ,331, ,142 6,000, /01/11 300, ,772 66,228 6,264, ,914 6,000, /01/12 300,000 1,500, ,772 66,228 4,698, ,685 4,500, /01/12 225, ,329 49,671 4,649, ,014 4,500, /01/13 225,000 1,500, ,329 49,671 3,099,343 99,343 3,000, /01/13 150, ,886 33,114 3,066,228 66,228 3,000, /01/14 150,000 1,500, ,886 33,114 1,533,114 33,114 1,500, /01/14 75,000-58,443 16,557 1,516,557 16,557 1,500, /01/15 75,000 1,500,000 58,443 16, ,000,