Exam 1 - Acct 414 - Fall 2006

Exam 1 – Acct 414 – Fall 2006 Page 13

Name: ______

Exam 1Acct 414 – Corporate Accounting & Reporting II Fall 2006

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. 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.

1-4. Time Value of Money (60 points total, 15 each)
5. Troubled debt (30 points total)
6. Leases. (70 points total)
7. Long-term contracts (20 points)
8. Serial Bonds (20 points)
Extra credit points (if any) total: ______
Total points earned (max = 200)

Do not attempt the extra credit items until you have completed all other sections of the exam!

1. Your employer needs to accumulate $2,000,000 in a sinking fund to repay a note coming due on December31, 2012. The company banks at Oregon First Bank & Trust which has committed to pay no less than 6% per annum on the account balance. Interest will be compounded semiannually on the account. The first deposit will be made on December 31, 2006 and the last of the deposits will be made on June 30, 2012. Determine the amount of the 12 equal deposits.

2. Assume that you are working for a leasing company. The original lease agreement specified an annual payment of $35,000 for five 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 $40,000). Since the leasing company bought the asset for $157,750, the original rate of return was about 14%. 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 $25,000 at the end of 5 years.

3. On October 31, 2006, Paul’s Produce Inc. purchased a machine for $100,000. The down payment was $5,000, 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 November30, 2006?

4. At December 31, 2006, 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 2006. 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 $45,000. (c) The principal and final interest payment is due on December 31, 2010. What is the implicit interest rate that Fancy Farms (the DEBTOR) will use to amortize this debt over the new terms? [Hint: the interest rate can be as low as 0%.]

5. Troubled Debt (30 points). Bobs Brakes Inc. is a major creditor of Adam’s Auto Repair Inc. Adam’s Auto Repair Inc. is experiencing substantial financial difficulties. Its original note with Bobs Brakes Inc. was dated August 1, 2005 and has a face value of $100,000 and specifies a 10% interest rate. The interest for the year ending August 1, 2006 has not been paid. On August 1, 2006, the debtor persuaded Bobs Brakes to reduce the principal from $100,000 to $70,000 and to reduce interest payments to $3,500 per year for the remaining 3-year life of the debt. The modified terms also waive payment of the accrued interest currently due. Both debtor and creditor have fiscal years that coincide with the calendar year.

Instructions

a. Show all necessary entries on the books of the debtor (Adam’s Auto Repair) from August 1, 2006 through August 1, 2007.

b. What is the amount of the loss that Bobs Brakes Inc. (the creditor) will recognize? (No journal entry is required)

6. Lease Accounting. (70 points total) variation of S06 Acct 414 problem and one on Acct 301 S02 Exam 3

On May 31, 2006, Buffy Vans, Inc. (lessee) and Custom Vans Unlimited (lessor) sign a noncancelable lease with the following terms:

1. Term: 5 years / 2. Annual payment = $12,336
3. Implicit interest rate (known to lessee) 8% / 4. Est. fair value of asset at end of lease $10,000
5. Fair value of asset $60,000 / 6. Cost of asset $50,000
7. Incremental borrowing rate: 9% / 8. First payment is due immediately
9. Estimated useful life of asset: 8 years / 10. Purchase option at end of lease: $10,000
11. If the purchase option is not exercised, the lessee returns the asset to the lessor at end of five years. / 12. The lease payments appear to be collectible and there are no additional costs expected by the lessor.
13. Both lessor and lessee use the straight-line depreciation method (no salvage value) and have fiscal years that end on December 31. / 14. The lessor pays a 1% commission to its sales staff based on the fair market value of leased equipment.

a. What type of lease is this for Buffy Vans (the lessee) and for Custom Vans Unlimited (the lessor)? Explain briefly showing numeric computations. (12 points) Hint: Let me know that you know all the rules!

b. Regardless of your answer to part (a), assume this is a sales-type lease for the lessor. Prepare a lease amortization schedule for Custom Vans Unlimited for the first two years. (18 points)

Date / Lease Payment / Interest Revenue / Amortized Principal / Balance
0
1
2

c. Regardless of your answer to (a), assume that this is a sales-type lease for the lessor. Prepare the journal entries that the lessor would make at the inception of the lease on May 31, 2006. (15 points)

5/31/06

6 - continued (facts repeated for your convenience)
On May 31, 2006, Buffy Vans, Inc. (lessee) and Custom Vans Unlimited (lessor) sign a noncancelable lease with the following terms:

d. Regardless of your answer to a, assume the lease is a capital lease for the lessee. Prepare all necessary journal entries for the lessee, Buffy Vans Inc. at 5/31/06, 12/31/06 and 5/31/07. (25 points)

5/31/06

12/31/06

5/31/07

7. Long-term construction accounting (20 points)

Howard Construction Co. contracted to build a bridge for $3,000,000. Construction began in 2004 and was completed in 2005. Data relating to the construction are:

2004 2005

Costs incurred $990,000 $825,000

Estimated costs to complete 810,000 —

Howard uses the percentage-of-completion method.

Instructions

(a) How much revenue should be reported for 2004? Show your computation.

(b) Make the entry to record progress billings of $1,000,000 during 2004.

(d) How much gross profit should be reported for 2005? Show your computation.

8. Serial Bonds (20 points). On October 1, 2006, Chalion Corporation issued $3,000,000 in serial bonds. The bond principal will be repaid in $1,000,000 increments beginning on October 1, 2007 with the final payment to be made on October 1, 2009. The bonds pay interest semi-annually on Oct. 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 $2,897,850. (Hint: The effective simple interest rate per year is approximately 12%)

Instructions: Choose (a) for 20 points or choose (b) for a maximum of 17 points. You do not need to prepare amortization table. There is a 5 point bonus for doing both entries correctly.

a. Using the bonds outstanding method of amortizing bond discounts/premiums, prepare the bond issuer's necessary journal entries for Dec. 31, 2006 (end of fiscal year).

b. Using the effective interest method of amortizing bond discounts/premiums, prepare the bond issuer's necessary journal entries for Dec. 31, 2006 (end of fiscal year).

9. Extra Credit Matching (optional – 5 points maximum)

MATCHING: For each term, select the best phrase or description from the answers listed below. An answer may be used once, more than once, or not at all.

_____1. Implicit interest rate / _____4. Guaranteed residual value
_____2. Unearned interest / _____5. Initial direct costs
_____3. Continent rentals

CHOICES:

A. Depreciation expense related to the leased asset is reported on the lessor's income statement over the lease term. Operating lease (lessor)

B. The rate used by the lessee to determine the present value of the minimum lease payments if the lessee's incremental borrowing rate is less than the lessor's implicit interest rate (known to lesee). Incremental borrowing rate

C. Increases or decreases in lease payments based upon sales volume or machine useage. Contingent rentals

D. Always included in minimum lease payments unless there is a title transfer or a bargain purchase option. Guaranteed residual value.

E. Included in the lessor's gross investment, whether guaranteed or unguaranteed. Residual value

F. Included in the lessor's gross investment in lease. Unguaranteed residual value but so would a GRV

G. The rate used by the lessee to determine the present value of the minimum lease payments if the lessee's incremental borrowing rate is greater than the lessor's implicit interest rate (known to lessee). Implicit interest rate

H. Is not included in the minimum lease payments if it is large enough to assure that the lease will be renewed. Non-renewal penalty

I. Costs which are expensed immediately by lessor when the fair value of the leased asset exceeds its carrying value. Initial direct costs

J. The difference between the fair value of the leased asset and the total payments to be received over the lease term. Unearned interest

SOLUTIONS

5-a Debtor

The carrying value is $110,000. Under new terms, the total cash flows are less than the carrying value at $80,500 [70,000 + (3,500 * 3 years)] so the debtor recognizes a gain on restructuring. The new carrying value for the note payable is the TOTAL future cash flows.

Debtor journal entries / Debit / Credit
8/1/06 / Accrued interest payable / 10,000
Note payable (old) / 100,000
Gain on troubled debt restructuring / 29,500
Note payable (new) – valued at TOTAL future cash flows / 80,500
12/31/06 /

No entry at year end since interest rate

Has been effectively set at ZERO
8/1/06 / Interest expense / 0
Notes payable / 3,500
Cash / 3,500

5b-Creditor
The creditor finds the present value of the cash flows using the original interest rate
n=3; i=10%; pmt=3,500, FV=$70,000 – solve for PV = $61,296
Since the carrying value is $110,000, the creditor has a loss of $48,704

6. Lease accountinga. Lessee classification of the lease. There is no title transfer and no bargain purchase option. The lease term = 0.71 of economic life. PVMLP (computed n=5, pmt=12336, i=8%, fv=0) is $53,194.40 which is less than 90% of FMV (54,000.00). Therefore, the lease fails all 4 tests. This is an operating lease for lessee. This is also an operating lease for the lessor. There is no Title Transfer, no BPO, the lease term is less than 75% of the economic life of the asset, and the PVMLP=53,194.23 which is less than 90% FMV. Note that there are no cost uncertainties and the payments are considered collectible from lessee (the two extra lessor rules). Since there is a profit (FMV > cost), this would be a sales-type and not a direct financing lease EXCEPT it is an operating lease because none of the first 4 criteria are met.

b. amortization table (first 2 rows required)

Instructions were not clear – I accepted either lessee or lessor table for part b. Note that lessor and lessee amortization tables are different even though both are using same interest rate (8% known to lessee). The reason is the unguaranteed residual value which does not appear on lessee’s table. Making the lessee journal entries was easier if you did the lessee table.