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ACCOUNTING 201FALL 2000

EXAM 2

Name: ________________________________________

Student #: _____________________________________

Instructor: Catherine Schrand

INSTRUCTIONS:

1. This is a 75-point exam (1 minute per point). Budget your time carefully.

2. There should be 11 pages in this test booklet. Make sure this booklet has all pages.

3. Answer the problems in the space provided only within this booklet. Present work in aneat and orderly fashion to facilitate the awarding of partial credit.

4. Please print your name and student number in the space provided above and write yourname on (or initial) all subsequent pages of this booklet.

5. There is a bonus question at the end. Do it only if you have extra time!

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Points Assigned Points Scored

I. Short problems 45

II. Financial Statements (Monarch) 30

75

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I. Short Problems (45 Points)

1. (2 points) Bank overdrafts, if material, should

a) be reported as a deduction in the current asset section of the balance sheetb) be reported as a deduction from cashc) be netted against cash and a net cash amount reportedd) be reported as a current liability.

2. (6 points) Cebar Co. adopted the dollar value LIFO method on January 1, 1998. Following isa schedule of (a) inventory amounts at prices existing on the given date and (b) price levels.

Inventory Price level

January 1, 1998 $280,000 100

December 31, 1998 $214,000 107

December 31, 1999 $308,000 112

Compute the amount Cebar will report for inventory at December 31, 1998 and 1999 under thedollar-value LIFO method.

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3. Recycling and Environmental Machinery Corp. (R.E.M.) is a custom builder of heavymachinery used in the recycling business. For long-term contracts, R.E.M. uses the percentageof completion method to record revenue, and the cost-to-cost basis for assessing the percentagecomplete. R.E.M. has no incomplete contracts at the beginning of 1999. During 1999, R.E.M.enters into a single contract to build equipment for a customer. The total contract price thatR.E.M. will receive is $2,000. Estimated information at contract signing follows.

1999 2000 2001Accumulated costs 300 720 1,500Projected costs to complete 1,200 780 0

Accumulated billings 340 1,000 2,000Accumulated cash collections 310 980 1,800

a) (10 points) Assume all estimates turn out to be correct as of the end of 1999. For each of theline items below on R.E.M.’s balance sheet and income statement related to this transaction,indicate the amount that will be reported for the first year of the contract (1999). Note that youranswer may be zero.

1999

Balance sheet

Accounts receivable

Costs and estimated earnings in excess of billings

Billings in excess of costs and estimated earnings

Construction in progress

Billings

Income statement

Revenue on long term contracts

Cost of long-term contracts

Net earnings on long-term contracts (This is not a subtotal of theprevious two amounts. It is a separate line item.)

b) (3 points) Now assume that it is the end of year 2 (2000), and the accounting for year 1 wasdone properly (above). R.E.M. estimates that the total cost of the contract, when complete, willbe $2,300. What is the net effect of this contract on pretax income for the year 2000?

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4. The Beautiful South Furniture Co. engages in the following two transactions during 2000related to its accounts receivable. For each event, record the entry at the time the event takesplace and any necessary adjusting entries for the year ended December 31, 2000.

a) (10 points) On January 1, Beautiful South allows a customer to convert its account receivableto a note. At the time of conversion, the customer’s account balance is $10,000. There areno interest payments on the note; the $10,000 is due at December 31, 2002. In exchange, thecustomer promises to arrange and sponsor the annual holiday party for Beautiful Southemployees. The party's value cannot be reliably estimated. The party is held in mid-December 2000 and is a big success! The appropriate interest rate for a note of similar risk is10%.

(Note: If Beautiful South were to pay for a party, it would account for the payment using anaccount called “Prepaid entertainment expense”, and it would account for the use of the prepaidamount using an account called "Entertainment expense".)

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Beautiful South, continued

b) (6 points) On December 20, 2000, Beautiful South decides it needs cash. It sells $400,000 ofaccounts receivable to a factor with recourse. The factor retains 2% for returns and alsocharges a finance fee of 8%. Beautiful South determines that the recourse obligation has afair value of $58,000. At the date of sale, there are no allowances against these receivables.Beautiful South records returns when they occur (i.e., they do not use the allowance method).There are no returns or defaults as of December 31, 2000.

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5. (8 points) A "friend" sets you up on a blind date with a student from Penn State: Pat. After theusual introductory chit-chat, Pat says, "Wow, you’re a Wharton student? You must know allabout finance and accounting and you know, business stuff. My psychic advisor says that theSEC is getting tough on the revenue recognition problem, but I have no idea what that means."At first you are speechless, impressed with Pat's use of three and even four syllable words.However, you recover quickly and answer Pat's question. Explain to Pat 1) what the revenuerecognition "problem" is, and 2) how the SEC is getting "tough" by giving one specific example.

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II. Financial Statements -- Monarch (30 points)

Revenue recognition

1. (2 points) See the discussion of Monarch's backlog on the first page of the financial statementsand circle the only true statement among the following:

a) The $49.253 million backlog is included in 1998 revenue and would have beenregardless of Monarch's shipping policy.

b) The $49.253 million backlog is included in 1998 revenue but only because "the entirebacklog can reasonably be expected to be shipped within twelve months."

c) The $49.253 million backlog is not included in 1998 revenue because revenue cannever be recognized until units are shipped.

d) The $49.253 million backlog is not included in 1998 revenue but Monarch expects toinclude it in 1999 revenue.

Long-term contracts (Refer to note 5)

2. (3 points) Assume that all of Monarch's contracts are profitable. If the total of the contractprices for all contracts that are still incomplete as of December 31, 1998 is $26,000, then what isthe average percentage of completion on these contracts as of December 31, 1998?

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Financial Statements -- Monarch, continued

Receivables:3. (2 points) What amount of bad debts expense did Monarch recognize during 1998?

4. (4 points) What was the unadjusted balance in the "Allowance for doubtful accounts" atDecember 31, 1998?

5. (2 points) Monarch typically does not pledge accounts receivable as collateral (in securedborrowing transactions). However, prior to year end 1998, Monarch had the opportunity toengage in a secured borrowing transaction if it promised to pledge 10% of its gross accountsreceivable (i.e., before the allowance for doubtful accounts) as collateral. If Monarch hadentered into this secured borrowing arrangement, what would be the balance of "Accountsreceivable, net of allowance for doubtful accounts" on the balance sheet at December 31, 1998?

6. (2 points) In footnote 9, Monarch indicates that it has outstanding notes receivable atDecember 31, 1998 (see bold) included in "Other assets" on the balance sheet. What is thepresent value of the remaining future cash flows related to these notes at December 31, 1998?Assume the effective or implied discount rate on all notes receivable held by Monarch is 10%.

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Financial Statements -- Monarch, continued

Inventory: Assume that inventories are UNRELATED to the construction segment ofMonarch's business.

7. (5 points) On its balance sheet, Monarch reports inventories of $10,486 at December 31, 1998.Indicate whether each of the following statements about this amount is true or false. AssumeMonarch follows GAAP.

_________ The LIFO cost of inventory in stock at December 31, 1998 is greater than themarket value for a portion of its inventory.

_________ The reported amount ($10,486) represents LIFO cost of raw materials plus theLIFO costs of production for WIP and finished goods inventory (costs of rawmaterials plus labor and overhead).

_________ This amount includes shipping charges from suppliers to Monarch for items instock.

_________ This amount includes an allocation of depreciation charges on Monarch'sproduction equipment.

_________ Inventory that is not on Monarch's premises is not included in this amount.

8. (6 points) For the year ended December 31, 1998, compute the best approximation forMonarch's inventory turnover ratio and the average number of days to sell inventory on a"current cost" basis. NOTE: I am asking for "cost" and, moreover, "current" cost.

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Financial Statements -- MonarchInventory, continued

9. The historical trend in the # of days to sell inventory (computed using financial statement dataon a current-cost basis) has been:

1997 1996 199589.5 81.2 74.8

Provide two distinct explanations that are consistent with the observed trend from 1995 - 1998.If you didn't get an answer to Q8, assume the number of days for 1998 is 100. (4 points)

BONUS QUESTION:Refer to footnote 4, and assume that all of the "reductions in inventory" in 1996 relate to finishedgoods. (Note that this is 1996 and there is no allowance for obsolete inventory.) If finishedgoods inventory quantities were reduced by 100,000 units during 1996, and the LIFO-cost of theunits in inventory at December 31, 1996 was $64.8 per unit, what was the current (or FIFO) costof production of those units at December 31, 1996? (Remember, figures in the footnotes arequoted in thousands.)