Exam 1 with Solutions - Corporate Accounting and Reporting | ACCT 414, Exams of Accounting

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Exam #___________

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Name: __________________________________ Exam 1 Acct 414 – Corporate Accounting & Reporting II Fall 2008 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. 1-3. Time Value of Money (45 points total)

4. Loan Impairment (30 points total)
5. Leases (70 points total) IFRS points______________ (items b, c & d) US GAAP points____________ (items a & e)
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 = __________/__________ = _________% Quiz and HW percentage = ___________% Projects percentage = ___________%

1. Assume that you are working for a leasing company. The original lease agreement specified an annual

payment of $40,000 for six years. 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 $25,000 at the end of the lease (when the estimated fair

value will be $50,000). Since the leasing company bought the asset for $205,000, the original rate of return

was about 13%. 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 $25,

at the end of 6 years. [15 points]

REQUIRED: The implicit interest rate = _______________________%

2. Armand Corporation wants to accumulate $500,000 on December 31, 2018 to retire preferred stock. The

company plans to deposit $100,000 in a savings account on January 1, 2009 which will earn interest at 8%

compounded quarterly. Armand Corporation wants to know what additional amount it has to deposit at the

end of each quarter for 10 years to have $500,000 available at the end of 2018. The periodic deposits will

also earn interest at 8% compounded quarterly. [15 points]

REQUIRED: What is the amount of the necessary quarterly deposit? $_____________________

3. Lessor. Assume that you are working for a leasing company. The boss asks you to compute the monthly lease payment that the company should charge to earn a 12% return on the following lease: Fair market value of leased asset $360,000. The first payment on lease will be made immediately upon signing and the second payment will be made at the end of the first month. The lease term is 4 years and the useful life of the asset is 6 years. At the end of the lease, the lessee must return the leased asset to the leasing company. The leasing company estimates that the asset will be worth $80,000 at the end of the lease term. [15 points] REQUIRED: What is the monthly payment? $__________________________

4. Loan impairment (troubled debt) As of October 31, 2008, Fancy Farms owes Idaho First Bank and Trust $50,000 at 12% interest. Fancy Farms has been unable to make any payments toward principal or interest during 2008. A troubled debt restructuring is negotiated with the following terms: (a) The interest rate is reduced to 10%. (b) Interest will be paid annually on a reduced balance of $40,000. (c) The principal and final interest payment is due on October 31, 2012. Instructions Show any entries needed on the books of the creditor, Idaho First Bank & Trust at the following dates – note the variations in revenue recognition methods shown by each date. [30 points] October 31, 2008, Date of restructuring (assuming the bank uses the effective interest method to recognize revenue) December 31, 2008, end of fiscal year (assuming the bank uses the effective interest method to recognize revenue) December 31, 2008, end of fiscal year (assuming the bank uses the cost recovery method to recognize revenue)

5.

Lease Accounting. On October 1, 2008, Joy Jewelers (lessee) and Franklin Fixtures Corp.

(lessor) signed a lease with the following terms:

1. Term: 8 years 2. Annual payments of $27,

3. Implicit interest rate (not known to lessee) 10% 4. Lessor retains ownership of asset at end of lease

5. Fair value of asset $180,000 6. Cost of asset $175,000 (not known to lessee)

7. Incremental borrowing rate: 12% 8. First payment due upon signing

9. Estimated useful life of asset: 11 years 10. No collection or cost uncertainties for lessor

11. Est. fair value of asset at end of lease: $35,000 12. The residual value is NOT guaranteed by lessee

13. A commission of 1% of the fair value of the leased asset is

paid to the salesperson who negotiated the lease.

14. Lessor and lessee both use straight-line depreciation for

fixed assets and have fiscal years that end on December 31

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 and whether the IFRS classification is better than the US GAAP answer. [

points]

Problem 5 (continued) Repeat of facts: On October 1, 2008, Joy Jewelers (lessee) and Franklin Fixtures Corp. (lessor) signed a lease with the following terms:

1. Term: 8 years 2. Annual payments of $27,

3. Implicit interest rate (not known to lessee) 10% 4. Lessor retains ownership of asset at end of lease

5. Fair value of asset $180,000 6. Cost of asset $175,000 (not known to lessee)

7. Incremental borrowing rate: 12% 8. First payment due upon signing

9. Estimated useful life of asset: 11 years 10. No collection or cost uncertainties for lessor

11. Est. fair value of asset at end of lease: $35,000 12. The residual value is NOT guaranteed by lessee

13. A commission of 1% of the fair value of the leased asset is

paid to the salesperson who negotiated the lease.

14. Lessor and lessee both use straight-line depreciation for

fixed assets and have fiscal years that end on December 31

c. Regardless of your answer to part b, assume that Joy 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 10/1/ 1 10/1/ d. Regardless of your answer to (b), assume that ( under IFRS ) the lease is a finance lease for Joy Jewelers. Provide the necessary journal entries to record the transactions for Joy Jewelers (the lessee) at October 1, 2008 and December 31, 2008 (15 points) 10/1/08 –under IFRS – LESSEE 12/31/

Problem 5 (continued) Repeat of facts: On October 1, 2008, Joy Jewelers (lessee) and Franklin Fixtures Corp. (lessor) signed a lease with the following terms:

1. Term: 8 years 2. Annual payments of $27,

3. Implicit interest rate (not known to lessee) 10% 4. Lessor retains ownership of asset at end of lease

5. Fair value of asset $180,000 6. Cost of asset $175,000 $180,000 (not known to lessee)

7. Incremental borrowing rate: 12% 8. First payment due upon signing

9. Estimated useful life of asset: 11 years 10. No collection or cost uncertainties for lessor

11. Est. fair value of asset at end of lease: $35,000 12. The residual value is NOT guaranteed by lessee

13. A commission of 1% of the fair value of the leased asset is

paid to the salesperson who negotiated the lease.

14. Lessor and lessee both use straight-line depreciation for

fixed assets and have fiscal years that end on December 31

e. Regardless of your answer to part a, assume that the lessor has a direct financing 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 10/1/ 1 10/1/ 10/1/08 – US GAAP – for LESSOR 12/31/08 (end of fiscal year)

6. Fair Value Option. Margaret Inc. has one asset, a bond issued by Mead Company that Margaret Inc. purchased at face value as an investment (accounted for at fair value as trading security). Margaret Inc. has only one liability, a bond that was issued at face value to finance the purchase of the Mead Company bond. There is no initial shareholder investment.

Terms of the bonds Mead Company Bond

Investment

Margaret Inc. Bond Payable

Face value $100,000 $100,

Coupon rate (annual) 12% 10%

Term 10 years 8 years

Semiannual interest payment $6,000 $5,

Yield rate at year end (simple interest) 11% 9%

a. Prepare a balance sheet for Margaret Company 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 Bonds payable Bond Investment Owner’s equity Total Total b. Prepare a balance sheet for Margaret Company at the END of the first year assuming that the fair value option was selected for the bond payable. Assets Liabilities & Owners Equity Cash Bonds payable Bond Investment Owner’s equity Total Total

9. Serial Bonds (20 points). (Based on A490 X1 F02, #6) On March 1, 2008, Krop Corporation issued $3,000,000 in serial bonds. The bond principal will be repaid in $1,000,000 increments beginning on March 1, 2009 with the final payment to be made on March 1, 2011. The bonds pay interest semi-annually on Sept. 1 and March 1. The coupon rate is 12% per annum. An investment banker handled the transaction and you have just received a check for $2,900,800. You may choose either the bonds outstanding method or the effective interest method of amortizing bond premiums. Check the appropriate box so I’ll know what you are attempting! Prepare the journal entry that would be needed on March 1, 2008 and Sept. 1, 2008. You do NOT need to prepare an amortization table – just the journal entry.  I’m using the bonds outstanding method for a maximum of 25 points.  I’m using the effective interest method for a maximum of 20 points. You may assume that the effective interest rate is 14% per annum. March 1, 2008 (issuance of bonds) Sept. 1, 2008 (first interest payment date)

SOLUTIONS

Problem 1 - determine implicit interest rate Problem 2 - accumlation to retire pfd stock Annual rate= n= 6 n= 40 8% pmt= 40,000.00 i= 2.00% pmts are quarterly pv= (205,000.00) PMT= fv= 25,000.00 pv= 100, ordinary annuity = 0; annuity due = 1 1 Face value = (500,000) i=? ordinary annuity=0;annuity due= 1 0 =rate 10.161% Solve for pmt $ 4,622. Problem 3 - Find lease payment Stated rate=^ Problem 4 - PV of troubled receivable Fair value (PV) $ (360,000) 12.00% n= 4 Yield rate 1% monthly i= 12.00% Number of payments 48 4 years PMT= (4,000) Future value (residual) 80,000 pv=? Solve for payment =PV Face value = (40,000) ordinary=0; due= 1 1 ordinary annuity=0;annuity due= 1 0 Solve for PV $8,092.55 =Pmt Solve for PV 37,570.

Problem 4 journal entries:

The creditor always finds the present value of the revised cash flows using the original interest rate (both

US GAAP and IFRS). In this case: PMT=$40,000 * 10% (new rate) = 4,000; i=12% (origin rate)’

FV=$40,000, n=4. Don’t forget to book remove accrued interest (old balance * original rate). For the

effective interest method, multiply new carrying value times original interest rate and prorate for partial

year. In this case: $37,570 * 12% = $4,508 * 2/12 = $751. No cash changes hands until Oct 31, 2009

(entry shown below was not required. Under the cost recovery method, no entry is needed at 12/31/

since we never accrue principal.

Creditor journal entries Debit Credit Accrued interest receivable 6, 10/31/2008 Note receivable (old) 50, Loss on loan impairment 18, Restructured note receivable 37, Cash - 56,000 56, 12/31/2008 Interest revenue 751 Interest receivable 751 2 Months to accrue at year end 0.166666667 Fraction of year 10/31/2009 Interest receivable 751 Interest revenue 3, Restructured note receivable 508 - Cash 4, Creditor's amortization table Using effective interest method Cash Int Rev Diff Balance 0 12.0% $37, 1 4,000 $4,508 508 38, 2 4,000 $4,569 569 38, 3 4,000 $4,638 638 39, 4 4,000 $4,714 714 40, 5 - total 16,000 18,430 2,

There is NO entry at 12/31/08 if the cost recovery method is used:

If the cost recovery method were used, no interest revenue would be recognized until

10/31/2012 and then a gain would be recognized for $18,

This is same amount that would be recognized as interest revenue under the effective interest rate

method.

5. Lease accounting a. It is an OPERATING LEASE under US GAAP. There is no title transfer and no bargain purchase option. The lease term is less than 75% of economic life. Therefore it is not a capital lease unless the PVMLP > 90% of fair value. Since the lessee doesn’t know the implicit rate, the fourth test is also failed and it is an operating lease under US GAAP. The PVMLP is $155,173 [n=8, i=12%, pmt=27,890, fv=0 (no BPO or GRV)] and this is less than $162,000 [$200,000 Fair value * 90%]. It is a SALES-TYPE LEASE under US GAAP. There is no title transfer, no bargain purchase option, and the lease term is only 73% of economic life. However, using the implicit interest rate of 10%, the lease passes the 90% of fair value test. [PVMLP = $163,670 using n=8, i=10%, pmt=27,890, fv=0 since it is unguaranteed] Both of the additional rules for the lessor are met. Since there is a small difference between fair value and cost, this is a sales-type lease for the lessor under US GAAP. b. Under IFRS, this would be a FINANCE lease for the lessee primarily because we use the lower of the incremental borrowing rate and the implicit rate if it can readily be calculated by the lessee. As you recall from the project, we readily computed implicit interest rates! However, even if you didn’t remember this point or thought it would not be practical to compute, the lease is 73% of economic life and the PVMLP is 78% of fair value so we are close to meeting two of the FIVE indicators. The five indicators under IFRS include the four discussed above (title transfer, bargain purchase option, majority of useful life, substantially all of fair value – the latter two without any bright lines). The fifth indicator is probably not relevant – leases of specialized assets are generally capitalized (i.e, finance lease). For the lessor, it would also be a FINANCE lease for the same reasons. IFRS doesn’t have the two extra rules for lessors (collectability, substantially complete costs). Accordingly, a lot of people would conclude that the IFRS makes more sense since the accounting is “parallel” between lessee and lessor. Some students argued that they like having the separate lessor classifications under US GAAP (i.e., direct financing vs. sales-type) and that is a good point since IFRS treats initial direct costs as they are handled under US GAAP but it is harder to talk about it since they just have “finance leases.” Some of you liked the flexibility provided by IFRS and others thought it would lead to abuse. I didn’t take off for your opinion – but you had to have one to get full credit! c. Prepare lessee amortization table under IFRS – so use 10% implicit rate rather than 12%. Lessee tables always start with PVMLP unless it is higher than FMV. I also accepted tables that started with $155,173. Starting with $180,000 does not earn full credit. Lease 10% Reduction in Lease Date Payment Interest Lease Obligation 163,670.20 Expense Obligation BALANCE 10/01/08 163,670. 0 10/01/08 27,890.00 0.00 27,890.00 135,780. 1 10/01/09 27,890.00 13,578.02 14,311.98 121,468. 2 10/01/10 27,890.00 12,146.82 15,743.18 105,725. 3 10/01/11 27,890.00 10,572.50 17,317.50 88,407. 4 10/01/12 27,890.00 8,840.75 19,049.25 69,358. 5 10/01/13 27,890.00 6,935.83 20,954.17 48,404. 6 10/01/14 27,890.00 4,840.41 23,049.59 25,354. 7 10/01/15 27,890.00 2,535.45 25,354.55 0.

d. Lessee journal entries under IFRS – therefore a FINANCE lease for the lessee – which is accounted for just like a capital lease in the US but I’ve used the implicit interest rate since it is lower than the incremental borrowing rate and (under IFRS) folks are supposed to be “smarter” about find the rate! LESSEE Joy Jewelers capital lease debit credit 10/01/08 Leased Asset 163,670. Lease Obligation 135,780. Cash 27,890. Useful life of asset: 8 because lessee returns asset to lessor at end of lease term YearFrac= 0. 12/31/08 Depreciation Expense 5,114. Accumulated Depreciation 5,114. 1/4 20,458. Interest Expense 3,394. Interest payable 3,394. 0.25 13,578. Under IFRS e. Lessor has to compute a new implicit rate because this is a direct financing lease with initial direct costs. I gave 2 points extra credit to those who computed the new rate. Lease Reduction LEASE Date Payment Interest in lease Receivable 181,800.00 181,800.00 9.6844% receivable BALANCE 10/01/08 181,800. 10/01/08 27,890.00 0.00 27,890.00 153,910. 10/01/09 27,890.00 14,905.28 12,984.72 140,925. 10/01/10 27,890.00 13,647.79 14,242.21 126,683. 10/01/11 27,890.00 12,268.51 15,621.49 111,061. 10/01/12 27,890.00 10,755.67 17,134.33 93,927. 10/01/13 27,890.00 9,096.31 18,793.69 75,133. 10/01/14 27,890.00 7,276.25 20,613.75 54,519. 10/01/15 27,890.00 5,279.92 22,610.08 31,909. 10/01/16 35,000.00 3,090.27 31,909.73 0. LESSOR Franklin Fixtures Corp debit credit DIRECT FINANCING LEASE 10/01/08 Net Investment in Lease 153,910. Cash 27,890. Initial direct costs: (assumes already booked) 1,800. Equipment held for lease 180,000. Yearfrac= total 181,800.00 181,800. 0.25000 Check this! Number of months 3 1/ 12/31/08 Interest Receivable 3,726. Interest Revenue 3,726. Prorated: 0.25 14,905. Under US GAAP

Problem 6 – Fair Value Option (FASB 159)

Under the fair value option, we can choose to recognize an asset or liability at its fair value rather than the “standard

accounting” for that item. In this example, the bond investment was a trading security so it would be carried on the

balance sheet at fair value regardless of the choice to use the FAS159 fair value option. However, we do not

currently account for bonds payable at fair value. Therefore, choosing the fair value option means that the liability

would be adjusted to fair value at each balance sheet date. Accordingly, the gain/loss on the investment would

partially offset the loss/gain on the liability – proving a “hedge” without the need for complex derivative instruments

and extensive documentation.

First step is to find the CURRENT (end of the year) fair values for each bond: Principal (FV) $ 100,000 $ 100,000 FV Yield rate 5.5% 4.5% =i Number of payments 18 14 =n PMT= 6,000 5,000 =PV ordinary=0; due=1 0 0 Solve for PV $105,623.04 $105,111.41 =fair value

Note that two periods have passed (semi-annual bond) and make sure to adjust annual rates to the equivalent semi-

annual rate or your fair values will be incorrect.

6a – fair value option is not adopted:

Assets

Liabilities & Owners

Equity

Cash 2,000 Bonds payable 100,

Bond Investment 105,623 Owner’s equity 7,

Total 107,623 Total 107,

6b. Fair value option is adopted for the bonds payable:

Assets

Liabilities & Owners

Equity

Cash 2,000 Bonds payable 105,

Bond Investment 105,623 Owner’s equity 2,

Total 107,623 Total 107,

Supporting computations: Beginning cash balance 0 Interest revenue 12, Interest expense -10, Ending cash 2, Income statements Fair value option Fair value option NOT adopted ADOPTED Interest revenue 12,000 12, Interest expense -10,000 -10, Gain/loss on bond investment 5,623 5, Gain/loss on bond payable 0 -5, Net income 7,623 2, These income statements confirm the balance sheets above. I didn’t ask for them. If you just put in the correct figures for cash and the two bonds, you can plug owners equity since under the basic accounting equation, assets minus liabilities equals owner’s equity!

Problem 7- serial bonds, amortization tables are not required and NOT NECESSARY for preparing journal entries.

Easiest is to do bonds outstanding method. Just count up the face values outstanding: 3M + 3M + 2M +

2M + 1M + 1M = $12 million total. So the discount/premium will be amortized with the 3/12 fraction for the

first 2 interest payments. Since this bond was issued at a discount, the amortization of the discount

INCREASES interest expense (as compared to interest paid). I’ve pasted in complete answers for study

purposes but the amortization tables are NOT necessary.

Journal entries: Bonds Outstanding Method Debit Credit 03/01/08 Cash 2,900, Discount on Bonds Payable 99, Bonds Payable 3,000, 09/01/08 Interest Expense PLUG 204, Discount on Bonds Payable 3/12 * 99,200 24, Cash 180, Date Interest Principal Interest Amorti- Carrying BALANCE FACE Paid Payment Expense zation Value DISCOUNT VALUE 03/01/08 - - - 2,900,800 (99,200) 3,000, 09/01/08 180,000 - 204,800 (24,800) 2,925,600 (74,400) 3,000, 03/01/09 180,000 1,000,000 204,800 (24,800) 1,950,400 (49,600) 2,000, 09/01/09 120,000 - 136,533 (16,533) 1,966,933 (33,067) 2,000, 03/01/10 120,000 1,000,000 136,533 (16,533) 983,467 (16,533) 1,000, 09/01/10 60,000 - 68,267 (8,267) 991,733 (8,267) 1,000, 03/01/11 60,000 1,000,000 68,267 (8,267) 0 - 0 12,000, Effective interest rate table using 14% -- doesn’t quite work since the actual rate is a bit lower: To use the effective interest rate, you need to know what it is – the 7% given is approximate. Computation of interest expense for effective interest method = carrying value $2,900,800 * 7% yield rate * 6/6 months. The interest payable (in this case, paid) is the coupon rate 6% * face value $3,000,000 * 6/6 months. We then BACK INTO the amortization of the premium. I’ve pasted in complete answers for study purposes but the amortization tables are NOT necessary. Journal entries: Effective Interest Method Debit Credit 03/01/08 Cash 2,900, Discount on Bonds Payable 99, Bonds Payable 3,000, 09/01/08 Interest Expense ($2,900,800 * 7% * 6/6) 203, Discount on Bonds Payable (PLUG) 23, Cash 180,000 ok 6.00% 7.000% Period Date Interest Principal Interest Amorti- Paid Payment Expense zation 0 03/01/08 0 0 0 1 09/01/08 180,000 203,056 (23,056) 2 03/01/09 180,000 1,000,000 204,670 (24,670) 3 09/01/09 120,000 136,397 (16,397) 4 03/01/10 120,000 1,000,000 137,545 (17,545) 5 09/01/10 60,000 68,773 (8,773) 6 03/01/11 60,000 1,000,000 69,387 (9,387)