Solution to Mid-Term Exam ADM4348M Winter 2011

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



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



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



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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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]


Interest Income......................................... 13,706[($415,000 $72,341) X .12 X 4/12]



Interest Income......................................... 24,915[($415,000 $72,341 - $31,222) X .12 X 8/12]


Interest Income......................................... 12,457[($415,000 $72,341 - $31,222) X .12 X 4/12]


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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)


Executory Expenses........................................ 14,400Cash.......................................................... 14,400


($72,341 X 4/12)



($72,341 X 8/12)


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)


(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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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

Documents

Solution to Mid-Term Exam ADM4348M Winter 2011