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Solution to Mid-Term Exam
ADM 4348M Winter 2011SPECIAL TOPICS IN FINANCIAL ACCOUNTING
March 1, 2011DMS 4140 17:30-20:30
Professor : Sheldon Weatherstone Duration: 3 hours
Instructions
1. Non-programmable calculators are permitted, but you cannot
share calculators.2. Books and notes are not permitted. 3. Please
do not ask the professor or the invigilator to explain or interpret
questions.
State any assumptions you feel are necessary.4. Write your
answers in the booklet provided.5. Hand back the signed examination
copy with your exam booklet(s).
STUDENT NAME: __________________________________________
STUDENT # : ________________________
Statement of Academic IntegrityThe School of Management does not
condone academic fraud, an act by a student that may result in a
falseacademic evaluation of that student or of another student.
Without limiting the generality of this definition,academic fraud
occurs when a student commits any of the following offences:
plagiarism or cheating of anykind, use of books, notes,
mathematical tables, dictionaries or other study aid unless an
explicit written noteto the contrary appears on the exam, to have
in his/her possession cameras, radios (radios with head sets),
taperecorders, pagers, cell phones, or any other communication
device which has not been previously authorizedin writing.
Statement to be signed by the student:I have read the text on
academic integrity and I pledge not to have committed or attempted
to commitacademic fraud in this examination.
Signed:______________________________________
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Note: an examination copy or booklet without that signed
statement will not be graded and will receive a finalexam grade of
zero.
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QUESTION 1 (40 marks)
The following information is available for the Flintstone
Corporations pension plan.Flintstone reports under private
enterprise accounting standards.
2011 2012 Accrued pension liability 1/1/2011 $ 10,000 -Accrued
benefit obligation 1/1/2011 175,000 -Fair value of plan assets
1/1/2011 165,000 - Current service cost, end of year 35,000
$47,250Discount rate and expected return 7% 10%Actual return on
plan assets 8% 6%Contributions, end of year 44,000 44,000Benefits
paid to retirees, end of year 24,000 26,000
On January 1, 2011, Flintstone Corp. amended its pension plan,
resulting in past servicecosts with a present value of $100,000.
The amendment of the pension plan is expected toprovide future
benefits up to the average eligibility date which is ten years from
now.There are no unamortized actuarial gains of losses as at
1/1/2011. There are also noactuarial gains or losses on the accrued
benefit obligation due to changes in actuarialassumptions during
the period under review (i.e. no actuarial re-evaluations
wereconducted as Flintstone commits to having them done only every
three years).
Instructions:
(a) Identify the plans funding status and the asset or liability
reported on theDecember 31, 2011 and 2012 balance sheets assuming
that Flintstone Corp.accounts for its pension with the deferral and
amortization approach under PEGAAP.
(b) Calculate the pension expense for 2011 and 2012 assuming
that Flintstone Corp.accounts for its pension with the deferral and
amortization approach under PEGAAP.
(c) Identify the plans funding status and the asset or liability
reported on theDecember 31, 2011 and 2012 balance sheets assuming
that Flintstone Corp.accounts for its pension with the immediate
recognition approach.
(d) Calculate the pension expense for 2011 and 2012 assuming
that Flintstone Corp.accounts for its pension with the immediate
recognition approach.
(e) Which method results in a better measure of expense over the
two year period?(f) Which method results in a better measure of the
funding status on the balance
sheet?
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Solution:
(a)
2011Accrued benefit obligation, 1/1/11 $175,000Past service cost
100,000
275,000Interest cost ($275,000 x 7%) 19,250Current service cost
35,000Benefits paid out (24,000 )
ABO, 12/31/11 $305,250
Plan assets, 1/1/11 $165,000Expected return on assets ($165,000
x 7%) 11,550Actuarial gain ($165,000 x (8% - 7%))
1,650Contributions 44,000Benefits paid out (24,000 )
Plan assets, 12/31/11 $198,200
Accounts reported on the balance sheet:
Accrued benefit obligation $(305,250)Plan assets at fair value
198,200
ABO in excess of plan assets (under-funded) (107,050
)Unamortized past service cost (100,000-10,000) 90,000Unamortized
Actuarial Gain (1,650)Accrued pension liability (10,000 + 52,700
44,000) ($18,700 )
2012Accrued benefit obligation, 1/1/12 $305,250Interest cost
($305,250 x 10%) 30,525Current service cost 47,250Benefits paid out
(26,000 )
ABO, 12/31/12 $357,025
Plan assets, 1/1/12 $198,200Expected return on assets ($198,200
x 10%) 19,820Actuarial Loss ($198,200 x (6% - 10%))
(7,928)Contributions 44,000Benefits paid out (26,000 )
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Plan assets, 12/31/12 $228,092
Accounts reported on the balance sheet:
Accrued benefit obligation $(357,025)Plan assets at fair value
228,092
ABO in excess of plan assets (under-funded) (128,933
)Unamortized past service cost (90,000 10,000) 80,000Unamortized
Actuarial Loss ((1,650) + 7,928) 6,278 Accrued pension liability
(18,700 + 67,955 - 44,000) ($42,655 )
Corridor Method:
Unamortized Actuarial (Gain)/Loss at 1/1/2011 010% of ABO
(larger than Plan Assets) at 1/1/2011 17,500Surplus to amortize
0
Unamortized Actuarial Gain at 1/1/2012 1,65010% of ABO (larger
than Plan Assets) at 1/1/2012 30,525Surplus to amortize 0
(b)
Pension expense 2011:Current service cost $ 35,000Interest on
accrued benefit obligation 19,250Expected return on plan assets
(11,550) Amortization of past service cost ($100,000 / 10)
10,000Amortization of Actuarial (Gain)/Loss (see corridor method
above) 0
$52,700
Pension expense 2012:Current service cost $47,250 Interest on
accrued benefit obligation 30,525Expected return on plan assets
(19,820) Amortization of past service cost ($100,000 / 10)
10,000Amortization of Actuarial Gain (see corridor method above)
0
$ 67,955
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(c)
2011Accrued benefit obligation, 1/1/11 $175,000Past service cost
100,000
275,000Interest cost ($275,000 x 7%) 19,250Current service cost
35,000Benefits paid out (24,000 )
ABO, 12/31/11 $305,250
Plan assets, 1/1/11 $165,000Expected return on assets ($165,000
x 7%) 11,550Actuarial gain ($165,000 x (8% - 7%))
1,650Contributions 44,000Benefits paid out (24,000 )
Plan assets, 12/31/11 $198,200
Accounts reported on the balance sheet:
Accrued benefit obligation $(305,250)Plan assets at fair value
198,200
ABO in excess of plan assets (under-funded) (107,050
)Unamortized past service cost 0Unamortized Actuarial Gain 0Accrued
pension liability (10,000 + 141,050 44,000) ($107,050 )
2012Accrued benefit obligation, 1/1/12 $305,250Interest cost
($305,250 x 10%) 30,525Current service cost 47,250Benefits paid out
(26,000 )
ABO, 12/31/12 $357,025
Plan assets, 1/1/12 $198,200Expected return on assets ($198,200
x 10%) 19,820Actuarial Loss ($198,200 x (6% - 10%)) (7,928)
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Contributions 44,000Benefits paid out (26,000 )
Plan assets, 12/31/12 $228,092
Accounts reported on the balance sheet:
Accrued benefit obligation $(357,025)Plan assets at fair value
228,092
ABO in excess of plan assets (under-funded) (128,933
)Unamortized past service cost 0Unamortized Actuarial Loss 0
Accrued pension liability (107,050 + 65,8323 - 44,000) ($128,933
)
(d)
Pension expense 2011:Current service cost $ 35,000Interest on
accrued benefit obligation 19,250Actual return on plan assets (8%
of $165,000) (13,200) Past service cost 100,000Actuarial
(Gain)/Loss 0
$141,050
Pension expense 2012:Current service cost $47,250 Interest on
accrued benefit obligation 30,525Actual return on plan assets (6%
of $198,200) (11,892) Past service cost 0Actuarial (Gain)/Loss
0
$ 65,833
(e) The deferral and amortization approach results in a more
stable expense numberon the income statement. The deferral and
amortization approach expense mayincrease each year, yet the
expense under the immediate recognition approach ismuch more
volatile.
(f) The immediate recognition approach results in a better
measure of the pensionplans unfunded liability on the balance sheet
in terms of expected future cashflows at an earlier date.
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QUESTION 2 (40 marks)
Mulholland Corp., a lessee, entered into a non-cancellable lease
agreement with Galt Manufacturing Ltd., a lessor, to lease special
purpose equipment for a period of seven years. Both Mulholland and
Galt follow private enterprise GAAP. The following information
relates to the agreement:
Lease inception May 2, 2011
Annual lease payment due at the beginning of each lease year
$?
Residual value of equipment at end of lease term, guaranteed
by
an independent third party $100,000
Economic life of equipment 10 years
Usual selling price of equipment $415,000
Manufacturing cost of equipment on lessors books $327,500
Lessors implicit interest rate, known to lessee 12%
Lessees incremental borrowing rate 12%
Executory costs per year to be paid by lessee, estimated
$14,500
The leased equipment reverts to Galt Manufacturing at the end of
the lease, although Mulholland has an option to purchase it at its
expected fair value at that time. Galt also has concluded that the
credit risk of Mulholland is normal and there are no unreimbursable
costs associated with this lease.
Instructions:
(a) Using time value of money tables or a financial calculator
calculate the lease payment determined by the lessor to provide a
12% return.
(b) Prepare a lease amortization table for Galt Manufacturing,
the lessor, covering theentire term of the lease.
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(c) Assuming that Galt Manufacturing has a December 31 year end,
and that reversing entries are not made, prepare all entries made
by the company up to and including May 2, 2013.
(d) Identify the balances and classification of amounts that
Galt Manufacturing will report on its December 31, 2011 balance
sheet, and the amounts on its 2011 income statement and statement
of cash flows related to this lease.
(e) Assuming that Mulholland has a December 31 year end, and
that reversing entriesare not made, prepare all entries made by the
company up to and including May 2,2013. Assume payments of
executory costs of $14,000, $14,400, and $14,950 covering fiscal
years 2011, 2012, and 2013, respectively.
(f) Identify the balances and classification of amounts that
Mulholland will report on its December 31, 2011 balance sheet, and
the amounts on its 2011 income statement and statement of cash
flows related to this lease.
(g) On whose balance sheet should the equipment appear? On whose
balance sheet does the equipment currently get reported?
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Solution:
(a) For the purpose of calculating the lease payment that will
yield a 12% returnto Galt, the residual value guaranteed by a third
party will be included in thecalculations below:
Using a financial calculator:PV $ (415,000)I 12%N 7 PMT $ ?
Yields $72,341FV $ 100,000 Type 1
(b)Galt Manufacturing Ltd. (Lessor)
Lease Amortization Schedule
Date
AnnualLease
PaymentPlus RV
Interest(12%) on NetInvestment
NetInvestmentRecovery
Balanceof Net
Investment
5/2/115/2/115/2/125/2/135/2/145/2/155/2/165/2/175/2/18
$ 72,34172,34172,34172,34172,34172,34172,341
100,000$606,387
$41,11937,37233,17628,47623,213
17,317 10,714
$191,387
$ 72,34131,22234,96939,16543,86549,12855,02489,286
$415,000
$415,000342,659311,437276,468237,303193,438144,31089,286
0
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(c)
5/2/11 Lease Payments
Receivable*................................. 606,387Cost of Goods
Sold................................................. 327,500
Sales.............................................................
415,000Inventory.....................................................
327,500Unearned Interest Income
Leases .......................................................
191,387* ($72,341 X 7) +$100,000
5/2/11 Cash
.....................................................................
72,341Lease Payments Receivable..................... 72,341
12/31/11 Unearned Interest IncomeLeases
....................................................... 27,413
Interest Income.........................................
27,413[($415,000 $72,341) X .12 X 8/12]
5/2/12 Unearned Interest IncomeLeases
....................................................... 13,706
Interest Income.........................................
13,706[($415,000 $72,341) X .12 X 4/12]
5/2/12 Cash
.....................................................................
72,341Lease Payments Receivable..................... 72,341
12/31/12 Unearned Interest IncomeLeases
....................................................... 24,915
Interest Income.........................................
24,915[($415,000 $72,341 - $31,222) X .12 X 8/12]
5/2/13 Unearned Interest IncomeLeases
....................................................... 12,457
Interest Income.........................................
12,457[($415,000 $72,341 - $31,222) X .12 X 4/12]
5/2/13 Cash
.....................................................................
72,341Lease Payments Receivable..................... 72,341
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(d)As at and for the period ending December 31, 2011Balance
sheet:Current assetsNet investment in leases $ 72,341
Noncurrent assets (investments) 297,731 *
* ($342,659 + $27,413 - $72,341 current)
Statement of income:Sales $ 415,000 Cost of goods sold 327,500
Gross profit 87,500 Interest income 27,413
Statement of cash flows:Operating Activities:Cash received for
lease $ 72,341
(e) Mulholland Corp. would account for the lease as an operating
lease since:
Using a financial calculator:PV $ ? Yields $369,764I 12%N 7 PMT
$ 72,341 FV $ 0 Type 1
The lease term (7 years) is less than 75% of the economic life
(10 years) of the leasedasset. The lease term is 70% (7 10) of the
assets economic life. There is nobargain purchase option and the
present value of minimum lease payments of$72,341 represents 89%
($369,764 / $415,000) of the fair value at May 2, 2011 of$415,000
falling short of the criteria of 90% to treat the lease as a
capital lease.
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Fiscal year ending December 31, 2011:During 2011:
Executory Expenses .......................................
14,000Cash..........................................................
14,000
5/2/11 Prepaid Rent
...................................................
72,341Cash..........................................................
72,341
12/31/11 Rent Expense
.................................................. 48,227Prepaid
Rent................................................. 48,227
($72,341 X 8/12)
Fiscal year ending December 31, 2012:During 2012:
Executory Expenses........................................
14,400Cash..........................................................
14,400
5/2/12 Rent Expense
.................................................. 24,114Prepaid
Rent................................................. 24,114
($72,341 X 4/12)
5/2/12 Prepaid Rent
...................................................
72,341Cash..........................................................
72,341
12/31/12 Rent Expense
.................................................. 48,227Prepaid
Rent................................................. 48,227
($72,341 X 8/12)
Fiscal year ending December 31, 2013:During 2010:
Executory Expenses .......................................
14,950Cash..........................................................
14,950
5/2/13 Rent
Expense...................................................
24,114
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Prepaid Rent.................................................
24,114($72,341 X 4/12)
5/2/13 Prepaid Rent
...................................................
72,341Cash..........................................................
72,341
(f)As at and for the period ending December 31, 2011
Balance sheet:Current assets:Prepaid rent $ 24,114
Statement of Income:Rent expense $ 48,227 Executory costs
14,000
Statement of cash flows:Operating Activities:Cash paid for lease
$ (72,341)
(g) In this set of circumstances, the equipment is on neither
the lessors (Galts)nor the lessees (Mulhollands) balance sheets.
The equipment should likelybe on the balance sheet of the lessor as
they have avoided recording the leaseas an operating lease by
involving a third party in the guaranteed residualvalue. In this
case, the present value of minimum lease payments represents89% of
the fair value of the asset. This is very close to the 90%
capitalizationcriteria guideline. The 90% criteria is not an
absolute rule and thereforeaccountants should look beyond the
numbers to the substance of thetransaction to determine the
accounting treatment of the lease; in this casecapitalization of
the lease may be a more meaningful presentation.
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QUESTION 3 (20 marks)
Answer the following questions directly on the examination
copy.
3.1 In a defined benefit plan, for the employer, the term
funding refers toa. being responsible for the assets of the pension
plan.b. determining the accumulated benefit obligation.c. making
periodic contributions to a funding agency to ensure that funds
are
available to meet retirees' claims.d. calculating the amount to
report for pension expense.
3.2 For a lessee, the minimum lease payments may includea. the
minimum rental payments and a guaranteed residual value only.b. the
minimum rental payments and a bargain purchase option only.c. a
bargain purchase option and a guaranteed residual value.d. the
minimum rental payments and a bargain purchase option or a
guaranteed
residual value.
3.3 Which of the following is a correct statement regarding one
of the ASPEcapitalization criteria?a. The lease transfers ownership
of the property to the lessor.b. The lease must contain a bargain
purchase option.c. The lease term is 75% or more of the leased
propertys estimated economic
life.d. The fair value of the minimum lease payments is equal to
90% or more of
the present value of the leased asset.
3.4 Using the deferral and amortization approach, unrecognized
net actuarial gains andlosses should bea. recorded currently as an
adjustment to pension expense in the period incurred.b. recorded
currently and in the future by applying the corridor method
which
provides the amount to be amortized.c. amortized over a 15-year
period.d. recorded only if a loss is determined.
3.5 Vested benefitsa. usually require a certain minimum number
of years of service.b. are those that the employee is entitled to
receive even if s/he is fired.c. are not contingent upon additional
service under the plan.d. are defined by all of these.
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3.6 On July 1, 2012, Nickel Ltd leases equipment from Dime Corp,
under an eight yearcapital (finance) lease. Equal annual payments
of $100,000 are required,payable on July 1 of each year. The first
payment is made on July 1, 2012. Theappropriate rate of interest
for this lease is 9%, and title will transfer to Nickel atthe end
of the lease contract. The fair value of the equipment is $620,000
andthe cost in Dime's accounting records is $550,000. The present
value of thelease payments is $620,000. What is the amount of gross
profit and interestincome that Dime would record for the year ended
December 31, 2012?a. $0 and $23,400.b. $0 and $36,000.c. $70,000
and $23,400.d. $70,637 and $23,400.
c. $620,000 $550,000 = $70,000. ($620,000 $100,000) .09 x 6/12 =
$23,400.
3.7 For a sales-type lease (called a manufacturer or dealer
lease in IFRS),a. the sales price includes the present value of the
unguaranteed residual value.b. the present value of the guaranteed
residual value is deducted to determine
the cost of goods sold.c. the gross profit will be the same
whether the residual value is guaranteed or
unguaranteed.d. cost of goods sold is not recognized.
3.8 Daikon Ltd. received the following information from its
pension plan trusteeconcerning their defined benefit pension plan
for the year ended December 31,2012. The corporation uses the
deferral and amortization approach.
Jan 1, 2012 Dec 31, 2012Fair value of plan assets $2,100,000
$2,250,000Accrued benefit obligation 2,400,000
2,580,000Unrecognized past service costs 270,000 240,000
For 2012, the current service cost is $180,000 and the
amortization of the pastservice costs is $30,000. The interest rate
on the liability is 10% and the expectedrate of return on plan
assets is 9%. What is the amount of pension expense for2012
assuming current service costs, contributions and benefits are at
the end ofthe year and no actuarial gains or losses are accounted
for?a. $265,500.b. $261,000.c. $216,000.d. $180,000.
b. $180,000 + $30,000 + ($2,400,000 .10) ($2,100,000 .09) =
$261,000.
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3.9 On January 1, 2012, Adams Corp signed a ten-year
non-cancellable lease formachinery. The terms of the lease called
for Adams to make annual paymentsof $100,000 at the end of each
year for ten years with title to pass to Adams atthe end of the
lease period. Adams accordingly accounted for this leasetransaction
as a capital (finance) lease. The machinery has an estimated
usefullife of 15 years and no residual value. Adams uses
straight-line depreciation forall of its property, plant and
equipment. The lease payments were determined tohave a present
value of $671,008 at an effective interest rate of 8%. It was
alsodetermined that the fair value of the machinery on January 1,
2012 was$671,008. With respect to this lease, for the year ending
December 31, 2012,Adams should report (rounded to the nearest
dollar)
a. lease expense of $100,000, and depreciation expense of
$44,933.b. interest expense of $53,681 and depreciation expense of
$44,933.c. interest expense of $53,681 and depreciation expense of
$44,734.d. interest expense of $53,920 and depreciation expense of
$67,101.
c. $671,008 .08 = $53,681; $671,008 15 = $44,734.
3.10 Presented below is pension information related to
Cantaloupe Ltd. for the year 2012.The corporation uses the
immediate recognition approach.
Current service cost $900,000Actual return on plan assets
210,000Interest on accrued benefit obligation 390,000Actuarial
experience loss 90,000Past service costs agreed to at Jan 1/12
165,000
The pension expense to be reported for 2012 isa. $1,515,000.b.
$1,395,000.c. $1,335,000.d. $1,155,000.
c. $900,000 + $390,000 + $90,000 + $165,000 $210,000 =
$1,335,000.
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Current service cost $ 35,000Current service cost $47,250Current
service cost $ 35,000Current service cost $47,250