BUSI 2002 – Intermediate Accounting II Chapter 13 – Current and NonFinancial Liabilities Additional Problems with Solutions Problem 1 Cranmore Corporation manufactures a line of amplifiers that carry a three-year warranty against defects. Based on experience, the estimated warranty costs related to dollar sales are as follows: first year after sale - 2% of sales; second year after sale - 3% of sales; and third year after sale - 4% of sales. Sales and actual warranty expenditures for the first three years of business were:

Sales

Warranty Expenditures

20x7 $810,000 $6,500 20x8 1,070,000 17,200 2009 1,036,000 62,000

Required - (a) Calculate the amount that Cranmore Corporation should report as warranty expense on its 20x9 income

statement and as a warranty liability on its December 31, 20x9, balance sheet. Assume that all sales are made evenly throughout each year and that warranty expenditures are also evenly spaced according to the rates above.

(b) Assume that Cranmore's warranty expenditures in the first year after sale end up being 4% of sales,

which is twice as much as was forecast. How would management account for this change? (c) Assume now that the CFO at Cranmore believes that the warranty provision should be discounted. If the

relevant discount rate is 6%, calculate the warranty expense for the years 20x7 through 20x8. Assume that all cash flows occur at year-end.

Problem 2 The following are selected transactions of Ping Department Store Ltd. for the current year ending December 3 1: 1. On February 2, the company purchased goods having cash discount terms of 2/10, n/30 from Haley

Limited for $50,000. Purchases and accounts payable are recorded using the periodic system at net amounts after cash discounts. The invoice was paid on February 26.

2. On April 1, Ping purchased a truck for $40,000 from Smith Motors Limited, paying $4,000 cash and

signing a one-year, 12% note for the balance of the purchase price. 3. On May 1, the company borrowed $80,000 from Second Provincial Bank by signing a $92,000 non-

interest-bearing note due one year from May 1. 4. On June 30 and December 31, Ping remitted cheques for $22,000 each as instalments on its current year

tax liability. 5. On August 14, the board of directors declared a $15,000 cash dividend that was payable on September

10 to shareholders of record on August 31. 6. On December 5, the store received $500 from Jackson Players as a deposit on furniture that Jackson

Players is using in its stage production. The deposit is to be returned to the theatre company after it returns the furniture on January 15.

7. On December 10, the store purchased new display cases for $9,000 on account. Sales tax of 5% and

GST of 6% were charged by the supplier on the purchase price. 8. During December, cash sales of $83,500 were recorded, plus a 5% sales tax and 6% GST that must be

remitted by the 15th day of the following month. Both taxes are levied on the sale amount to the customer.

9. Ping's lease for its store premises calls for a $2,500 monthly rental payment plus 3% of all sales. The

payment is due one week after month end. 10. Ping is required to restore the area surrounding one of its store parking lots, at an estimated cost of

$100,000, when the store is closed in two years. Ping estimates that the present value of this obligation at December 31 is $84,000.

11. The corporate tax return indicated taxable income of $210,000. Ping's income tax rate is 25%.

Required - (a) Prepare all the journal entries that are necessary to record the above transactions when they occurred and

any adjusting journal entries relative to the transactions that would be required to present fair financial statements at December 31. Date each entry.

(b) Identify the current liabilities that will be reported on the December 31 balance sheet, and indicate the

amount of each one. (c) Why is the liabilities section of the balance sheet of primary significance to bankers?

Problem 3 Selamou Corporation sells televisions at an average price of $850 and they come with a standard one-year warranty. The company also offers each customer a separate three-year extended warranty contract for $90 that requires the company to perform periodic services and replace defective pans. The extended warranty begins one year after the purchase date. During 20x8, the company sold 300 televisions and 270 extended warranty contracts for cash. Company records indicate that warranty costs in the first year after purchase average $25 per set: $15 for parts, and $10 for labour. Selamou estimates the average three-year extended warranty costs as $20 for pans and $40 for labour. Assume that all sales occurred on December 31, 20x8, and that all warranty costs are expected to be incurred evenly over the warranty period. Required - Answer (a) and (b) based on the information above. (a) Record any necessary journal entries in 20x8. (b) What liabilities relative to these transactions would appear on the December 3 1, 20x8, balance sheet

and how would they be classified? Answer (c) and (d) assuming that in 20x9 Selamou Corporation incurred actual costs relative to 20x8 television warranty sales of $4,410 for parts and $2,940 for labour. (c) Record any necessary journal entries in 20x9 relative to the 20x8 television warranties. (d) What amounts relative to the 20x8 television warranties would appear on the December 31, 20x9,

balance sheet and how would they be classified? Answer (e) and (f) assuming that in 2010 Selamou Corporation incurred the following costs relative to the extended warranties sold in 20x8: $2,000 for parts and $3,000 for labour. (e) Record any necessary journal entries in 2010 relative to the 20x8 television warranties. (f) What amounts relative to the 20x8 television warranties would appear on the December 31, 2010,

balance sheet and how would they be classified?

Problem 4 To stimulate the sales of its Krusch breakfast cereal, Khamsah Corporation , a private company who adopted ASPE, places one coupon in each cereal box. Five coupons are redeemable for a premium consisting of a child's hand puppet. In 20x8, the company purchased 31,000 puppets at $1.50 each and sold 440,000 boxes of Krusch at $3.50 a box. From its experience with other similar premium offers, the company estimates that 32% of the coupons issued will be mailed back for redemption. During 20x8, 105,000 coupons are presented for redemption. Required - (a) Prepare the journal entries that should be recorded in 20x8 relative to the premium plan. (b) How would the accounts resulting from the entries in (a) and (b) above be presented on the 20x8

financial statements? (c) Assume now that Khamsah is a publicly accountable company. Repeat part (a) assuming that the retail

value of each puppet is estimated to be $2.60 each.

Problem 5 Brooks Corporation sells portable computer equipment with a two-year warranty that requires the corporation to replace defective parts and provide the necessary repair labour. During 20x3, the corporation sells for cash 400 computers at a unit price of $2,500. Based on experience, the two-year warranty costs are estimated to be $155 for parts and $185 for labour per unit. The warranty is not sold separately from the equipment. During 20x4, 500 computers were sold for $2,700 cash. Warranty cost estimates were the same as for 20x3. Assume that in 20x3, the actual warranty costs incurred by Brooks Corporation were $32,200 for parts and $40,300 for labour. In 20x4, the actual warranty costs incurred by Brooks Corporation were $82,300 for parts and $98,000 for labour. Required – (a) Record the 20x3 and 20x4 journal entries. (b) What liability relative to these transactions would appear on the December 31, 20x4 balance sheet?

SOLUTION Problem 1 (a) On 20x9 sales: $1,036,000 x 9% $93,240 Warranty liability balance On 20x7 – 20x9 sales: $2,916,000 x 9% $262,440 Less warranty expenditures 85,700 $176,740 (b) The difference between actual warranty expenditures and the estimated amount

would be treated as a change in accounting estimate and applied to the current and future years. The difference would be used as part of Cranmore’s experience in setting the rate for current and future years’ transactions. If the difference is considered material, the additional warranty expenditures would be written off to the income statement in the current year.

(c) Present

Value Cash flows resulting from 20x7 sales: 20x8: $810,000 x 2% = $16,200 $15,283 20x9: $810,000 x 3% = $24,300 21,627 20x10: $810,000 x 4% = $32,400 27,204 $64,114 Cash flows resulting from 20x8 sales: 20x8: $1,070,000 x 2% = $21,400 $20,189 20x9: $1,070,000 x 3% = $32,100 28,569 20x10: $1,070,000 x 4% = $42,800 35,936 $84,694 Cash flows resulting from 20x9 sales: 20x8: $1,036,000 x 2% = $20,720 $19,547 20x9: $1,036,000 x 3% = $31,080 27,661 20x10: $1,036,000 x 4% = $41,440 34,794 $82,002

20x7 Warranty expense $64,114 Warranty liability $64,114 Warranty liability 6,500 Cash 6,500 20x8 Interest expense ($64,114 – 6,500) x 6% 3,457 Warranty liability 3,457 Warranty expense 84,694 Warranty liability 84,694 Warranty liability 17,200 Cash 17,200 20x8 Interest expense 7,714 Warranty liability 7,714 ($64,114 – 6,500 + 3,457 + 84,694

– 17,200) x 6%

Warranty expense 82,002 Warranty liability 82,002 Warranty liability 62,000 Cash 62,000

Problem 2 (a) 1. Feb 2 Purchases ($50,000 x 0.98) 49,000 Accounts Payable 49,000 Feb 26 Accounts Payable 49,000 Purchase discounts lost 1,000 Cash 50,000 2. Apr 1 Trucks 40,000 Note payable 36,000 Cash 4,000 Dec 31 Interest expense

(36,000 x 12% x 9/12) 3,240 Interest payable 3,240 3. May 1 Cash 80,000 Note payable 80,000 Dec 31 Interest expense (12,000 x 8/12) 8,000 Note payable 8,000 4. Jun 30 Income taxes payable 22,000 Cash 22,000 Dec 31 Income taxes payable 22,000 Cash 22,000 5. Aug 14 Retained Earnings 15,000 Dividends payable 15,000 Sep 10 Dividends payable 15,000 Cash 15,000 6. Dec 5 Cash 500 Returnable Deposit Liability 500 7. Dec 10 Display cases ($9,000 x 1.05) 9,450 GST Payable ($9,000 x 6%) 540 Accounts payable ($9,000 x 1.11) 9,900 8. Dec 31 Cash ($83,500 x 1.11) 92,685 Sales 83,500 PST Payable ($83,500 x 5%) 4,175 GST Payable ($83,500 x 6%) 5,010 9. Dec 31 Rent expense (2,500 + 83,500 x 3%) 5,005 Rent payable 5,005 10. Dec 31 Parking lot 84,000 ARO 84,000

11. Dec 31 Income tax expense 52,500 Income taxes payable 52,500 $210,000 x 25% (b) Current Liabilities: Accounts Payable $9,990 GST Payable ($5,010 - $540) 4,470 Sales Taxes Payable 4,175 Rental Payable 5,005 Income Taxes Payable 8,500 Notes Payable ($36,000 + 88,000) 124,000 Interest Payable 3,240 Returnable Deposit Liability 500 $159,880 © As a lender of money, the banker is interested in the priority his/her claim has on

the company’s assets relative to other claims. Close examination of the liability section and the related notes discloses amounts, maturity dates, collateral, subordinations, and restrictions of existing contractual obligations, all of which are important to potential and existing creditors. The assets and earning power are likewise important to a banker considering a loan.

Problem 3 a. Cash $279,300 Sales (300 x $850) $255,000 Unearned Warranty Revenue (270 x $90) 24,300 Warranty expense (300 x $25) 7,500 Warranty liability 7,500 b. Current liabilities Warranty liability $7,500 Long-term liabilities Unearned Warranty Revenue $24,300 c. Warranty liability $7,350 Parts inventory $4,410 Wages payable 2,940 Warranty liability 150 Warranty expense 150 d. Current liabilities Unearned Warranty Revenue ($24,300/3) $8,100 Long-term liabilities Unearned Warranty Revenue ($24,300/3 x 2) $16,200 e. Unearned Warranty Revenue $8,100 Warranty revenue $8,100 Sales Warranty Expense 5,000 Parts Inventory 2,000 Wages payable 3,000 f. Current liabilities Unearned Warranty Revenue ($24,300/3) $8,100 Long-term liabilities Unearned Warranty Revenue ($24,300/3 x 1) $8,100

Problem 4 a. Puppet Inventory (31,000 x 1.50) $46,500 Cash $46,500 Premium expense $42,240 Premium liability $42,240 440,000 boxes / 5 x $1.50 x 32% Premium liability 31,500 Puppet Inventory 31,500 b. Current Assets Puppet Inventory ($46,500 – 31,500) $15,000 Current liabilities Premium liability $10,740 Income Statement Premium expense $42,240 c. Cash/AR (440,000 x $3.50) 1,540,000 Deferred revenues* 73,216 Revenues 1,466,784 * 440,000 / 5 x $2.60 x 32% Puppet Inventory (31,000 x 1.50) 46,500 Cash 46,500 Deferred revenues (105,000/5 x $2.60) 54,600 Revenues 54,600 COGS (105,000/5 x $1.50) 31,500 Puppet Inventory 31,500

Problem 5 (a) 20x3 Cash (400 x $2,500) $1,000,000 Sales $1,000,000 Warranty expense (400 x $155 + 185) $136,000 Warranty liability $136,000 Warranty liability 72,500 Parts inventory 32,200 Wages payable 40,300 20x4 Cash (500 x $2,700) 1,350,000 Sales 1,350,000 Warranty expense (500 x $155 + 185) 170,000 Warranty liability 170,000 Warranty liability 180,300 Parts inventory 82,300 Wages payable 98,000 (b) The balance in the Warranty liability account will be: $136,000 – 72,500 + 170,000 - 180,300 = $53,200

BUSI 2002 – Intermediate Accounting II Chapter 14 – Long-Term Financial Liabilities Additional Problems with Solutions Problem 1 On January 1, 20x8, Greene Inc. makes the following acquisitions: 1. Purchases land having a fair market value of $200,000 by issuing a five-year, non-interest-bearing

promissory note in the face amount of $337,012. 2. Purchases equipment by issuing an eight-year, 6% promissory note having a maturity value of $275,000

(interest payable annually). Assume that the company’s incremental borrowing rate is 11%. Required - (a) Record Greene's journal entries on January 1, 20x8, for each of the purchases. (b) Record the interest at the end of the first two years on both notes using the effective interest method. (c) Record the interest at the end of the first year on both notes using the straight-line method. Problem 2 Three independent situations follow. Answer the questions at the end of each situation. Assume that the companies in question are publicly accountable. 1. Winans Corporation incurred the following costs when it issued bonds: (1) printing and engraving costs,

$25,000; (2) legal fees, $69,000; and (3) commissions paid to underwriter, $70,000. What accounting treatment could be given to these costs?

2. Gershwin Inc. sold $3 million of 10-year, 10% bonds at 104 on January 1, 20x8. The bonds were dated

January 1, 2008, and pay interest on July 1 and January 1. Determine the amount of interest expense to be reported on July 1, 20x8, and December 31, 20x8.

3. Kenoly Inc. issued $600,000 of 10-year, 9% bonds on June 30, 20x7, for $562,500. This price provided

a yield of 10% on the bonds. Interest is payable semi-annually on December 31 and June 30. Determine the amount of interest expense to record if financial statements are issued on October 31, 20x7.

Problem 3 On June 30, 20x8, Missy Limited issued $4 million of 20 year 13% bonds for $4,300,920, which provides a yield of 12%. The company uses the effective interest method to amortize any bond premium or discount. The bonds pay semi-annual interest on June 30 and December 31. Required - (a) Prepare the journal entries to record the following transactions:

1. The issuance of the bonds on June 30, 20x8 2. The payment of interest and the amortization of the premium on December 31, 20x8. 3. The payment of interest and the amortization of the premium on June 30, 20x9.

4. The payment of interest and the amortization of the premium on December 31, 20x9. (b) Show the proper balance sheet presentation for the liability for bonds payable on the December 31,

20x8, balance sheet. (c) Answer the following questions:

1. What amount of interest expense is reported for 20x8? 2. Will the bond interest expense that is reported in 20x8 be the same as, greater than, or less than

the amount that would be reported if the straight-line method of amortization were used? 3. What is the total cost of borrowing over the life of the bond? 4. Will the total bond interest expense for the life of the bond be greater than, the same as, or less

than the total interest expense if the straight-line method of amortization were used? Problem 4 On April 15, 2005, Jacques Breweries Co. issues a bond issue with a face value of $15,000,000. The bonds are dated March 1, 2005 and mature on March 1, 2020. The coupon rate is 6.5% and interest payment dates are on Aug 31 and February 28 of every year. The yield-to-maturity on April 15, 2005 is 8%. Jacques Breweries has a December 31 year end. The effective interest rate method is used. Required - a. Write all journal entries for the year 2005 and 2006 relative to the bond issue. b. Repeat the journal entries for the year 2005 on the assumption that the company incurred bond issue

costs of $250,000. c. On June 1, 2011 the company purchases and retires $5,000,000 of face value bonds on the open market

at 103. Write the journal entries on June 1, 2011 through December 31, 2011. Problem 5 The Low Quality Furniture Company allows you to purchase $5,000 of furniture on the following terms: i. 0% down, no interest for 2 years, full $5,000 to be repaid in 2 years ii. 50% down, no interest for 3 years, balance of $2,500 to be repaid in 3 years iii. 0% down, no interest for 5 years, required annual repayments of $1,000 at the end of each year for 5

years iv. 0% down, annual interest repayments of 5% for 4 years, balance payable at the end of 4 years v. 0% down, annual payments of $1,200 per year for 5 years. Assuming an imputed rate of 8%, and assuming that each of the above situation is independent, prepare all journal entries made by you for each of the situations for all years in question.

SOLUTION Problem 1 (a) Note 1: Interest rate implied = 11% N = 5, PV = 200,000, FV = -337,012, solve for I = 11% Note 2: N = 8, I = 11, PMT = 16500, FV = 275000, Solve for PV = $204,241 Jan 1, 20x8 Land $200,000 Note Payable $200,000 Equipment 204,241 Note payable 201,241 (b) Dec 31, 20x8 Interest expense ($200,000 x 11%) 22,000 Note payable 22,000 Interest expense ($204,241 x 11%) 22,467 Cash 16,500 Note payable 5,967 Dec 31, 20x9 Interest expense ($222,000 x 11%) 24,420 Note payable 24,420 Interest expense

($204,241 + 5,967) x 11% 23,123 Cash 16,500 Note payable 6,623 (c) Dec 31, 20x8 Interest expense 27,402 Note payable 27,402 ($337,012 – 200,000) / 5 Interest expense 25,345 Cash 16,500 Note payable ($275,000 – 204,241) / 8 8,845

Problem 2 1. Reduce the book value of the bonds by the amount of bond issue costs. This

implies that a YTM must be calculated to properly amortize the discount or premium.

2. We need a YTM: N = 20, PV = 3,120,000, PMT = -150,000, FV = -3,000,000 Solve for I = 4.6875% Interest expense for first half of 20x8: $3,120,000 x 4.6875% = $146,250 Amortization of premium = $150,000 – 146,250 = 3,750 Interest expense for second half of 20x8: ($3,120,000 – 3,750) x 4.6875% = 146,074 Total interest = $146,250 + 146,074 = $292,324 3. $562,500 x 10% x 4/12 = $18,750

Problem 3 (a) 1. Cash $4,300,920 Bonds Payable $4,300,920 2. Interest expense ($4,300,920 x 6%) 258,055 Bonds payable 1,945 Cash 260,000 3. Interest expense

($4,300,920 – 1,945) = $4,298,975 x 6% 257,939 Bonds payable 2,061 Cash 260,000 4. Interest expense

($4,298,975 – 2,061) = $4,298,975 x 6% 257,815 Bonds payable 2,185 Cash 260,000 (b) Bonds payable, 13%, due June 30, 2028 $4,298,975 (c) 1. $258,055 2. Straight line amortization of premium would be: $300,920 / 40 = $7,523 Interest expense each 6 months would be: $260,000 – 7,523 = $252,477 Therefore, lower under straight-line. 3. Total coupon payments: $260,000 x 40 $10,400,000 4. The same.

Problem 4 a. PV at April 15, 2005: N = 30, I = 4, PMT = 487500, FV = 15000000 Solve for PV = 13,054,646 Accrued interest collected on April 15 = $487,500 x 1.5 / 6 = $121,875 Apr 15, 2005 Cash $13,054,646 Bonds Payable $13,054,646 Cash 121,875 Interest Expense 121,875 Aug 31, 2005 Interest expense* 522,186 Bonds payable 34,686 Cash 487,500 * 13,054,646 x 4% Dec 31, 2005 Interest expense* 349,049 Bonds payable 24,049 Interest payable (487,500 x 4/6) 325,000 * (13,054,646 + 34,686

= 13,089,332 x 4% x 4/6) Feb 26, 2006 Interest expense* 174,524 Interest payable 325,000 Bonds payable 12,024 Cash 487,500 * (13,089,332 x 4% x 2/6) Aug 31, 2005 Interest expense* 525,016 Bonds payable 37,516 Cash 487,500 * (13,089,332 + 24,049 + 12,024

= 13,125,405 x 4% ) Dec 31, 2005 Interest expense* 351,011 Bonds payable 26,011 Interest payable (487,500 x 4/6) 325,000 * (13,125,405 + 37,516

= 13,162,921 x 4% x 4/6)

b. The net proceeds on the bond issue will be $250,000 less, or $12,804,646

($13,054,646 – 250,000). We need to find the YTM based on a PV of $12,804,646.

N = 30, PV = 12,804,646, PMT = -487,500, FV = -15,000,000 Solve for I = 4.11 Apr 15, 2005 Cash $12,804,646 Bonds Payable $12,804,646 Cash 121,875 Interest Expense 121,875 Aug 31, 2005 Interest expense* 526,271 Bonds payable 38,771 Cash 487,500 * 12,804,646 x 4.11% Dec 31, 2005 Interest expense* 351,910 Bonds payable 26,910 Interest payable (487,500 x 4/6) 325,000 * (12,804,646 + 38,771

= 12,843,417 x 4.11% x 4/6)

c. Book Value of Bond issue at March 1, 2011: N = 18, I = 4, PMT = 487500, FV = 15000000 Solve for PV = 13,575,829 June 1, 2011 Interest expense* 271,517 Bonds payable 27,767 Interest payable (487,500 x 3/6) 243,750 * $13,575,829 x 4% x 3/6 Book value of bonds payable at June 1, 2011 = $13,575,829 + 27,767 = $13,603,596 Book value of bonds retired = $13,603,596 x 1/3 = $4,534,532 June 1, 2011 Bonds payable $4,534,532 Loss on redemption of bonds 615,468 Cash ($15,000,000 x 1/3 x 1.03) 5,150,000 In addition, we will have to pay the bondholders for 3 months of accrued interest: $487,500 x 1/3 x 1/2 = $81,250 June 1, 2011 Interest payable 81,250 Cash 81,250 Aug 31, 2011 Interest expense* 181,011 Interest payable ($243,750 - 81,250) 162,500 Bonds payable 18,511 Cash ($487,500 x 2/3) 325,000 * $13,575,829 x 4% x 1/2 x 2/3 The Balance in the Bonds payable account at Aug 31, 2011 is $13,575,829

+ 27,767 – 4,534,532 + 18,511 = $9,087,575 Check: N = 17, I = 4, PMT = 325,000, FV = 10,000,000 Solve for PV = 9,087,575 Dec 31, 2011 Interest expense* 242,335 Bonds payable 24,668 Interest payable

(487,500 x x 2/3 x 4/6) 216,667 * (9,087,575 x 4% x 4/6)

Problem 5 Part (i) PV of note: N = 2, I = 8, FV = 5000, solve for PV = 4,287 Initial Furniture $4,287 Note payable $4,287 End Yr 1 Interest expense (4,287 x 8%) 343 Note payable 343 End Yr 2 Interest expense (4,287 + 343) x 8% 370 Note payable 370 Note payable 5,000 Cash 5,000 Part (ii) PV of note: N = 3, I = 8, FV = 2500, solve for PV = 1,985 Initial Furniture $4,485 Cash $2,500 Note payable 1,985 End Yr 1 Interest expense (1,985 x 8%) 159 Note payable 159 End Yr 2 Interest expense (1,985 + 159) x 8% 172 Note payable 172 End Yr 3 Interest Revenue (1,985 + 159 + 172) x 8% 184 Note payable 184 Note payable 2,500 Cash 2,500

Part (iii) PV of note: N = 5, I = 8, PMT = 1000, solve for PV =$ 3,993 Initial Furniture $3,993 Note payable $3,993 End Yr 1 Interest expense (3,993 x 8%) 319 Note payable 681 Cash 1,000 End Yr 2 Interest expense (3,993 - 681) = 3,312 x 8% 265 Note payable 735 Cash 1,000 End Yr 3 Interest expense (3,312 - 735) = 2,577 x 8% 206 Note payable 794 Cash 1,000 End Yr 4 Interest expense (2,577 - 794) = 1,783 x 8% 143 Note payable 857 Cash 1,000 End Yr 5 Interest expense (1,783 - 857) = 926 x 8% 74 Note payable 926 Cash 1,000

Part (iv) PV of note: N = 4, I = 8, PMT = 250, FV = 5000, solve for PV = $4,503 Initial Furniture $4,503 Note payable $4,503 End Yr 1 Interest expense (4,503 x 8%) 360 Note payable 110 Cash 250 End Yr 2 Interest expense (4,503 + 110) = 4,613 x 8% 369 Note payable 119 Cash 250 End Yr 3 Interest expense (4,613 + 119) = 4,732 x 8% 369 Note payable 119 Cash 250 End Yr 4 Interest expense (4,732 + 129) = 4,861 x 8% 389 Note payable 139 Cash 250 Note payable 5,000 Cash 5,000

Part (v) PV of note: N = 5, I = 8, PMT = 1200, solve for PV = $4,791 Initial Furniture $4,791 Note payable $4,791 End Yr 1 Interest expense (4,791 x 8%) 383 Note payable 817 Cash 1,200 End Yr 2 Interest expense (4,791 - 817) = 3,974 x 8% 318 Note payable 882 Cash 1,200 End Yr 3 Interest expense (3,974 - 882) = 3,092 x 8% 247 Note payable 953 Cash 1,200 End Yr 4 Interest expense (3,092 - 953) = 2,139 x 8% 171 Note payable 1,029 Cash 1,200 End Yr 5 Interest expense (2,139 - 1,029) = 1,110 x 8% 90 Note payable 1,110 Cash 1,200

BUSI 2002 – Intermediate Accounting II Chapter 15 – Shareholders’ Equity Additional Problems with Solutions Problem 1 Kao Corporation is authorized to issue 500,000 common shares. During 2008, the company took part in the following selected transactions: 1. Issued 5,000 shares at $35 per share, less $3,000 in costs related to the issuance of the shares. 2. Issued 2,000 shares for land with a fair value of $150,000. The shares were actively traded on a national

stock exchange at approximately $46 per share on the date of issuance. 3. Purchased and retired 500 of the company's shares at $43 per share. The repurchased shares have an

average per share amount of $40. Required - (a) Prepare the journal entries to record the three transactions listed. (b) When shares are repurchased, is the original issue price of those individual shares relevant? Explain.

Problem 2 The following are selected transactions that may affect shareholders' equity: 1. Recorded accrued interest earned on a note receivable. 2. Declared a cash dividend. 3. Effected a stock split. 4. Recorded the expiration of insurance coverage that was previously recorded as prepaid insurance. 5. Paid the cash dividend declared in item 2 above. 6. Recorded accrued interest expense on a note payable. 7. Recorded an increase in the value of an FVTOCI investment that will be distributed as a property

dividend. The carrying value of the FVTOCI investment was greater than its cost. 8. Declared a property dividend (see item 7 above). 9. Distributed the investment to shareholders (see items 7 and 8 above). 10. Declared a stock dividend. 11. Distributed the stock dividend declared in item 10. 12. Repurchased common shares for less than their initial issue price. Required - In the table below, indicate the effect that each of the 12 transactions has on the financial statement elements that are listed. Use the following codes: increase (I), decrease (D), and no effect (NE).

Acc. Other Shareholders’ Share Cont. Retained Compr. Net

Item Assets Liabilities Equity Capital Surplus Earnings Income Income

Problem 3 Feller Corp. reported the following amounts in the shareholders' equity section of its December 31, 20x7, balance sheet: Preferred shares, $8 dividend (10,000 shares authorized, 2,000 shares issued) $200,000Common shares (100,000 authorized, 25,000 issued) 100,000 Contributed surplus 155,000 Retained earnings 250,000 Accumulated other comprehensive income 75,000 $780,000 During 20x8, the company had the following transactions that affect shareholders' equity: 1. Paid the annual 20x7 $8 per share dividend on preferred shares and a $3 per share dividend on common

shares. These dividends had been declared on December 31, 20x7. 2. Purchased 3,700 shares of its own outstanding common shares for $35 per share and cancelled them. 3. Issued 1,000 shares of preferred shares at $105 per share (at the beginning of the year). 4. Declared a 10% stock dividend on the outstanding common shares when the shares were selling for $45

per share. 5. Issued the stock dividend. 6. Declared the annual 20x8 $8 per share dividend on preferred shares and a $2 per share dividend on

common shares. These dividends are payable in 20x9. The contributed surplus arose from past common share transactions. Required - (a) Prepare journal entries to record the transactions above. (b) Prepare the December 31, 20x8, shareholders' equity section. Assume 20x8 net income was $450,000

and comprehensive income was $455,000. (c) Prepare the statement of shareholders' equity for the year ended December 3 1, 20x8. Problem 4 Transactions of Kalila Corporation are as follows: 1. The company is granted a charter that authorizes the issuance of 150,000 preferred shares and 150,000

common shares without par value. 2. The founders of the corporation are issued 10,000 common shares for land valued by the board of

directors at $210,000 (based on an independent valuation).

3. Sold 15,200 preferred shares for cash at $110 per share. 4. Repurchased and cancelled 3,000 shares of outstanding preferred shares for cash at $100 per share. 5. Repurchased and cancelled 4,000 preferred shares for cash at $98 per share. 6. Repurchased for cash and cancelled 500 shares of the outstanding common shares issued in number 2

above at $49 per share. 7. Issued 2,000 preferred shares at $99 per share. 8. Repurchased 600 preferred shares for $120. Required - (a) Prepare entries in journal form to record the transactions listed above. No other transactions affecting the

capital share accounts have occurred. (b) Assuming that the company has retained earnings from operations of $1,032,000, prepare the

shareholders' equity section of its balance sheet after considering all the transactions above.

Problem 5 Amado Limited has two classes of shares outstanding: preferred ($6 dividend) and common. At December 31, 20x7, the following accounts and balances were included in shareholders' equity: Preferred shares, 300,000 shares issued (authorized, 1 million shares) $ 3,000,000Common shares, 1,000,000 shares (authorized, unlimited) 10,000,000 Contributed surplus-preferred 200,000 Contributed surplus-common 17,000,000 Retained earnings 5,500,000 Accumulated other comprehensive income 250,000 The following transactions affected shareholders' equity during 20x8: Jan 1 Issued 25,000 preferred shares at $25 per share. Feb. 1 Issued 50,000 common shares at $20 per share. June 1 Declared a 2-for-I stock split (common shares). July 1 Purchased and retired 30,000 common shares at $15 per share. Dec 31 Net income is $2,100,000; comprehensive income is $2,050,000. Dec 31 The preferred dividend is declared, and a common dividend of $0.50 per share is declared. Required - Prepare the shareholders' equity section for the company at December 31, 20x8. Show all supporting calculations.

Problem 6 The Babra Company’s shareholders’ equity at December 31, 20x5 is as follows: Preferred shares, $5, 300,000 shares issued and outstanding $25,000,000Common shares, 2,000,000 shares issued and outstanding 65,000,000Retained earnings 26,000,000 $116,000,000 The preferred share dividend was last paid on December 31, 20x1. Required – For each of the following independent situations, show the total dividend payout for both common and preferred shareholders.

(a) The preferred shares are noncumulative and nonparticipating. The company wants to pay a total dividend of $2,000,000.

(b) The preferred shares are cumulative and nonparticipating. The company wants to pay a total dividend of $8,000,000.

(c) The preferred shares are cumulative and fully participating. The company wants to pay a total dividend of $15,000,000.

(d) The preferred shares are cumulative and fully participating. The company wants to pay a common share dividend of $5.00 per share.

SOLUTIONS Problem 1 (a) 1. Cash [(5,000 x $35) – 3,000] 172,000 Common Shares 172,000 2. Land 150,000 Common Shares 150,000 3. Common shares (500 x $40) 20,000 Retained earnings 1,500 Cash 21,500 (b) Share repurchases are recorded at the average issue price per share, or the average

price at which the shares were issued for that class of shares. The original issue price of the individual shares being repurchased is not used. The original issue price of the individual shares repurchased would be considered in the total issue price for the class of shares but would be averaged with all other shares of the same class.

Problem 2

Item

Assets

Liab.

S/E

Share Cap.

Cont. Surplus

R/E

OCI

Net Inc.

1. I I I I 2. I D D 3. 4. D D D D 5. D D 6. I D D D 7. I I I D I 8. I D D 9. D D 10. I D 11. 12. D D D I

Problem 3 (a) 1. Dividends payable $91,000 Cash $91,000 (2,000 x $8) + (25,000 x $3) 2. Common shares (3,700 x 4) 14,800 Contributed Surplus 114,700 Cash (3,700 x $35) 129,500 3. Cash (1,000 x $105) 105,000 Preferred Shares 105,000 4. Retained earnings (21,300 x 10% x $45) 95,850 Stock dividend distributable 95,850 5. Stock dividend distributable 95,850 Common stock 95,850 6. Retained earnings 70,860 Dividends payable 70,860 (3,000 x $8) + (23,430 x $2) (b) Share capital Preferred shares, $8, 10,000 shares authorized, 3,000 shares issued $ 305,000 Common shares, 100,000 shares authorized, 23,430 shares issued 181,050 Contributed surplus 40,300 Retained earnings 533,290 Accumulated other comprehensive income 80,000 Total shareholders’ equity $1,139,640

(c) Preferred

SharesCommon

SharesCont

Surplus R/E OCI Balance, Jan 1 $200,000 $100,000 $155,000 $250,000 $75,000 Net income 450,000 Increase in OCI 5,000 Issue of preferred

shares 105,000

Purchase of common shares

(14,800) (114,700)

Stock Dividend 95,850 (95,850) Cash Dividend s - Preferred (24,000) - Common (46,860) $305,000 $181,050 $40,300 $533,290 $80,000

Problem 4 (a) 1. No entry 2. Land $210,000 Common shares $210,000 3. Cash (15,200 x $110) 1,672,000 Preferred shares 1,672,000 4. Preferred shares (3,000 x $110) 330,000 Contributed Surplus - Preferred 30,000 Cash (3,000 x $100) 300,000 5. Preferred shares (4,000 x $110) 440,000 Contributed Surplus - Preferred 48,000 Cash (4,000 x $98) 392,000 6. Common Shares (500 x $21) 10,500 Retained earnings 14,000 Cash (500 x $49) 24,500 7. Cash (2,000 x $99) 198,000 Preferred Shares 198,000 8. The book value/share = $1,100,000 / 10,200 = $107.84 Preferred shares (600 x $107.84) 64,704 Contributed Surplus 7,296 Cash (600 x $120) 72,000 (b) Shareholders’ Equity Preferred Shares, no par value, authorized 150,000 shares,

issued 9,600 shares $1,035,296

Common Shares, no par value, authorized 150,000 shares, issued 9,500 shares 199,500

Contributed surplus 70,704 Retained earnings ($1,032,000 – 14,000) 1,018,000 $2,323,500

Problem 5 Jan 1 Cash (25,000 x $25) $625,000 Preferred shares $625,000 Feb 1 Cash (50,000 x $20) 1,000,000 Common shares 1,000,000 June 1 No entry July 1 Common shares (30,000 x $5.24) 157,200 Contributed Surplus - Common 292,800 Cash (30,000 x $15) 450,000 ($10,000,000 + 1,000,000) / [(1,000,000 + 50,000) x 2] = $5.24 Dec 31 Retained Earnings 2,985,000 Dividends payable – preferred 1,950,000 (325,000 x $6) Dividends payable – common (2,100,000 – 30,000) x 0.50 1,035,000 Amado Limited Shareholders’ Equity As at December 31, 20x8 Preferred shares, $6, 1,000,000 shares authorized, 325,000 shares issued and outstanding $ 3,625,000Common shares, unlimited shares authorized, 2,070,000 shares issued and outstanding 10,842,800Contributed surplus 16,907,200Retained earnings 4,615,000Accumulated other comprehensive income 200,000 $36,190,000

Problem 6 Preferred Common

(a) Preferred: 300,000 x $5 $1,500,000 $500,000 (b) Preferred: $1,500,000 x 4 years 6,000,000 2,000,000 (c) Preferred: $1,500,000 x 4 years 6,000,000 Common: $65,000,000 x 6%* 3,900,000 Participating: Preferred: $5,100,000 x 25/90 1,416,667 Common: $5,100,000 x 65/90 3,683,333 $7,416,667 $7,583,333 (d) We want the total common dividends to be $5.00 x 2,000,000 shares

= $10,000,000

The participating component needs to be $10,000,000 – 3,900,000 = $6,100,000

The excess dividend needs to be $6,100,000 x 90/65 = $8,446,154 Preferred Common

Preferred: $1,500,000 x 4 years $6,000,000 Common: $65,000,000 x 6%* $3,900,000 Participating: Preferred: $8,446,154 x 25/90 2,346,154 Common: $8,446,154 x 65/90 6,100,000 $8,346,154 $10,000,000

BUSI 2002 – Chapter 16 – Complex Financial Instruments Tutorial Problem Solutions Problem 1 On January 2, 20x2 the Solomons Company issued 140,000 stock options to their executive team and senior managers. The market price of the company's stock on January 2, 20x2 was $16. The exercise or strike price of the options was also $16. The employment contract stated that the executives had to provide services to Solomons Company for the period January 1, 20x2 to December 31, 20x4. The stock options were exercisable in the fiscal year ended December 31, 20x5. The Black-Scholes model puts the market value at $2.25 per option. At the end of 20x2, management estimates that 95% of the stock options will vest. At the end of 20x3, this estimate was revised to 90%. At December 31, 20x4 the actual number of options that vested amounted to 120,000. During 20x5, 90,000 of the options were exercised when the stock price was $28 per share. The remaining 30,000 options expired at December 31, 20x5. The total value of the options on the date of grant is: 140,000 x $2.25 = $315,000. Prepare the journal entries for the years 20x2 through to 20x5. Problem 2 On January 3, 20x4 the Bailey Company granted 200,000 stock options to its executives. The exercise price of the options is $25 and was equal to the stock price on that date. An option pricing model puts the total value of these stock options at $125,000. The options are exercisable during the fiscal period ending December 31, 20x6 on the condition that the executives are still in the employ of Bailey Company as of December 31, 20x5. The Bailey Company estimates that 80% of the stock options will vest at December 31, 20x4. The actual number of options that vested on December 31, 20x5 was 175,000. During the year 20x6, 160,000 options were exercised and the remaining 15,000 options expired. Required – Prepare the journal entries for the years 20x4 through to 20x6

Problem 3 50 executives are given a stock option grant of 1,000 options each on January 2, 20x4. The vesting period is 4 years and the market value of each option is estimated to be $20. It is estimated that 75% of the options will vest. At the end of 20x5 (the second year), management estimates that 80% of the executives will remain. This estimate still holds for the year ended December 31, 20x6. At the end of 20x7, there are 41 executives left. Required - Calculate compensation expense for the years 20x4 - 20x7. Problem 4 Hannah Ltd. issued $8,000,000 of 8 year, 6% convertible bonds on December 31, 20x5 for proceeds of $7,950,000. Interest is payable on June 30 and Dec 31 of every year. Similar bonds without conversion privileges yield 7%. On July 1, 20x8, $2,500,000 of these bonds are converted into 40,000 common shares. The market value of the shares on that date was $75 per share. Required – a. Prepare the journal entry to record the issuance of the bonds on December 31, 20x5. b. Prepare the journal entries to record interest expense for the year 20x6. c. Prepare the journal entry to record the conversion of the bonds on July 1, 20x8. d. Assume that the balance of the bonds are retired at maturity. Prepare the journal entry to record

the retirement of the bonds. Problem 5 The Jerome Corporation issued $10,000,000 of 10 year, 7% bonds on December 31, 20x2 for total proceeds of $10,597,000. Each $1,000 bond came with 6 detachable warrants allowing the holder to purchase one share of the corporation within the next 2 years at a price of $25, the market price of the stock on December 31, 20x2. The yield to maturity on debt with similar maturity and risk is 6.6%. Required – a. Prepare the journal entry to record the issuance of the bonds on December 31, 20x2. b. Assume that on July 2, 20x4, 40,000 warrants are converted into common stock. The stock was

trading at $60 on that date. Prepare the journal entry to record the exercise of the warrants. Problem 6 On January 2, 20x1, an entity grants 50 cash share appreciation rights (SARS) to each of its 1,200 employees, on condition that the employees remain in its employ for the next three years.

During 20x1, 60 employees leave. The entity estimates that a further 150 will leave during years 20x2 - 20x3. During 20x2, 90 employees leave and the entity estimates that a further 100 will leave during 20x3. During 20x3, 80 employees leave. At the end of 20x3, 320 employees exercise their SARs, another 450 employees exercise their SARs at the end of 20x4 and the remaining 200 employees exercise their SARs at the end of 20x5. The entity estimates the fair value of the SARs at the end of each year in which a liability exists as shown below. At the end of year 3, all SARs held by the remaining employees vest. The intrinsic values of the SARs at the date of exercise (which equal cash paid out) at the end of years 20x3, 20x4 and 20x5 are also shown below.

Fair Intrinsic Year value value

1 $18.50 2 20.60 3 22.40 $23.50 4 19.60 20.50 5 18.20

Analyze the liability account related to the SARS provision and write up the journal entries for the years 20x1 to 20x5. Problem 7 On June 1, 20x4 you purchase 10,000 shares of the Harry Corporation for $7.50 per share and classify the shares as FVTOCI. On the same day you purchase a put option contract to sell 10,000 shares of the Harry Corporation at an exercise price of $7.50. The cost of the contract is $300. You have designated the purchase of the put options as a hedge against the investment of the Harry Corporation shares. Required – a. Write the journal entries on June 1, 20x4 b. Write the journal entries on December 31, 20x4 assuming that the shares of the Harry

Corporation are trading at $5.50 and that the value of the put option contract is $22,000.

Problem 8 On January 2, 20x3, you issue 15 year bonds with a face value of $50,000,000 paying LIBOR + 2%. The LIBOR rate at that date is 5.5%. In order to hedge any future interest rate fluctuations, you enter into a 15 year interest rate swap agreement with a third party whereby you agree to pay a fixed amount of interest of 7.5% on a notional value of $50,000,000. In exchange, you will receive a variable rate of interest equal to LIBOR + 2%. Assume interest is paid annually. You have designated the investment as a hedge and will use hedge accounting. Required – a. Write the journal entries on January 2, 20x3. b. Write the journal entries on December 31, 20x3 assuming that the LIBOR rate is 4.2% and that

the value of the swap agreement has dropped by $80,000. c. Write the journal entries on December 31, 20x3 assuming that the LIBOR rate is 6.7% and that

the value of the swap agreement has increased by $90,000. Problem 9 On January 1, 20x7, when its common shares were selling for $80 per share, Plato Corp. issued $10 million of 8% convertible debentures due in 20 years. The conversion option allowed the holder of each $1,000 bond to convert the bond into five common shares. The debentures were issued for $10.8 million. The bond payment's present value at the time of issuance was $8.5 million and the corporation believes the difference between the present value and the amount paid is attributable to the conversion feature. On January 1, 2008, the corporation's common shares were split 2 for 1, and the conversion rate for the bonds was adjusted accordingly. On January 1, 20x9, when the corporation's common shares were selling for $135 per share, holders of 30% of the convertible debentures exercised their conversion option. Required - (a) Prepare in general journal form the entry to record the original issuance of the convertible

debentures. (b) Prepare in general journal form the entry to record the exercise of the conversion option. Show

supporting calculations in good form. (c) How many shares were issued as a result of the conversion? (d) From the perspective of Plato Corp., what are the advantages and disadvantages of the

conversion of the bonds into common shares?

Problem 10 On January 2, 20x7, Jones Corporation purchased a call option for $200 on Merchant common shares. The call option gives Jones the option to buy 1,000 shares of Merchant at a strike price of $40 per share. The market price of a Merchant share was $40 on January 2, 2007 (the intrinsic value was therefore $0). On March 31, 20x7, the market price for Merchant stock was $53 per share, and the value of the option was $13,200. Required - (a) Prepare the journal entry to record the purchase of the call option on January 2, 20x7. (b) Prepare the journal entry (ies) to recognize the change in the call option's fair value as of March

31, 20x7. (c) What was the effect on net income of entering into the derivative transaction for the period

January 2 to March 31, 20x7? (d) Based on the available facts, explain whether the company is using the option as a hedge or for

speculative purposes. Problem 11 On November 1, 20x8, Columbo Corp. adopted a stock option plan that granted options to key executives to purchase 32,000 common shares. The options were granted on January 2, 20x9, and were exercisable two years after the date of grant if the grantee was still a company employee; the options expire six years from the date of grant. The option price was set at $40 and, using an option pricing model to value the options, the total compensation expense was estimated to be $450,000. On April 1, 20x10, 2,000 options were terminated when some employees resigned from the company. The market value of the shares at that date was $32. All of the remaining options were exercised during the year 20x11: 20,000 on January 3 when the market price was $62, and 10,000 on May 1 when the market price was $77 a share. Required - Prepare journal entries relating to the stock option plan for the years 20x9, 20x10, and 20x11. Assume that on December 31, 20x9, management estimates that 95% of the stock options will vest. Assume a December 31 year-end.

Problem 12 On January 1, 20x8, Biron Corp. issued $1.2 million of five-year, zero-interest-bearing notes along with warrants to buy 1 million common shares at $20 per share. On January 1, 20x8, Biron had 9.6 million common shares outstanding and the market price was $19 per share. Biron Corp. received $1 million for the notes and warrants. If offered alone, on January 1, 20x8, the notes would have been issued to yield 12% to the creditor. Required – (a) Prepare the journal entry (ies) to record the issuance of the zero-interest-bearing notes and

warrants for the cash consideration that was received. (b) Prepare an amortization table for the note. (c) Prepare adjusting journal entries for Biron Corp. at the end of its fiscal year of December 31,

20x8.

Problem 13 On December 31, 20x7, Mercantile Corp. had a $10-million floating rate (LIBOR + 0%) loan outstanding that was payable in two years. It decided to enter into a two-year swap with First Bank to convert the floating-rate debt to fixed-rate debt. The terms of the swap specified that Mercantile will pay interest at a fixed rate of 8% and will receive a variable rate equal to the six-month LIBOR rate, based on the $10-million amount. The LIBOR rate on December 31, 20x7, was 7%. The LIBOR rate will be reset every six months and will be used to determine the variable rate to be paid for the following six-month period. Mercantile Corp. designated the swap as a cash flow hedge. Assume that the hedging relationship meets all the conditions necessary for hedge accounting. The six-month LIBOR rate and the swap fair values were as follows: Date 6-Month LIBOR Rate Swap Fair Value Dec 31, 20x7 7.0% Jun 30, 20x8 7.5% $(200,000) Dec 31, 20x8 6.0% 60,000 Required - (a) Present the journal entries to all transactions relating to these transactions for the year ending

Dec 31, 20x8. (b) Indicate the amount (s) reported on the statement of financial position and income statement

related to the debt and swap on December 31, 20x7. (c) Indicate the amount (s) reported on the statement of financial position and income statement

related to the debt and swap on June 30, 20x8. (d) Indicate the amount (s) reported on the statement of financial position and income statement

related to the debt and swap on December 31, 20x8.

SOLUTIONS Problem 1 Dec 31, 20x2 Compensation expense

($315,000 x 1/3 x 95%) $99,750 Contributed Surplus

– Unexpired Stock Options $99,750The compensation expense for the 20x3 is calculated as follows:

Cumulative value of the stock options earned for the period 20x2 - 20x3: $315,000 x 2/3 x 90% $189,000Less cumulative compensation expense to the end of 20x2 99,750Compensation expense - 20x3 $ 89,250

Dec 31, 20x3 Compensation expense 89,250 Contributed Surplus

– Unexpired Stock Options 89,250

The compensation expense for the 20x4 is calculated as follows:

Cumulative value of the stock options earned for the period 20x2 - 20x4: 120,000 options vested x $2.25 $270,000Less cumulative compensation expense to the end of 20x3: $99,750 + 89,250 189,000Compensation expense - 20x4 $ 81,000

Dec 31, 20x4 Compensation expense 81,000 Contributed Surplus

– Unexpired Stock Options 81,000

In 20x5, we record the conversion of 90,000 options. Note that the stock market price at that date is not relevant to this transaction. 20x5 Cash (90,000 x $16) 1,440,000 Contributed Surplus

– Unexpired Stock Options (90,000 x $2.25) 202,500

Common stock 1,642500

Finally, on December 31, 20x5 we record the expiration of the remaining 30,000 stock options: Dec 31, 20x5 Contributed Surplus

– Unexpired Stock Options 67,500 Contributed Surplus 67,500 30,000 x $2.25 Problem 2 Dec 31, 20x4 Compensation expense

($125,000 x 1/2 x 80%) $50,000 Contributed Surplus

– Unexpired Stock Options $50,000 The compensation expense for the 20x5 is calculated as follows:

Cumulative value of the stock options earned for the period 20x4 - 20x5: $125,000 x 100% x 175,000 / 200,000 $109,375Less cumulative compensation expense to the end of 20x4 50,000Compensation expense - 20x5 $ 59,375

Dec 31, 20x5 Compensation expense 59,375 Contributed Surplus

– Unexpired Stock Options 59,375 20x6 Cash (160,000 x $25) 4,000,000 Contributed Surplus

– Unexpired Stock Options ($109,375 x 160,000 / 175,000) 100,000

Common stock 4,100,000 Dec 31, 20x5 Contributed Surplus

– Unexpired Stock Options 9,375 Contributed Surplus 9,375

Problem 3 20x4 50,000 options x $20 x 75% x ¼ $187,500 20x5 Cumulative compensation expense to end of 20x5: 50,000 options x $20 x 80% x 2/4 $400,000 Less 20x4 compensation expense 187,500 $212,500 20x6 Cumulative compensation expense to end of 20x6: 50,000 options x $20 x 80% x 3/4 $600,000 Less cumulative compensation expense to end of 20x5:

$187,500 + 212,500 400,000 $200,000 20x7 Total cumulative compensation expense to the end of 20x7:

1,000 shares x 41 executives x $20 $820,000 Less cumulative compensation expense to end of 20x6:

$187,500 + 212,500 + 200,000 600,000 $220,000

Problem 4 a. The proceeds that would have been received had the bonds not been convertible are:

N I/Y PV PMT FV Enter 16 3.5 240000 8000000 Compute X =

7,516,235

The journal entry to record the issuance of the bonds is as follows:

Cash $7,950,000 Bonds payable $7,516,235 Contributed Surplus – Conversion Rights 433,765

b. Interest expense ($7,516,235 x 3.5%) 263,068 Bonds Payable 23,068 Cash 240,000 Interest expense

($7,516,235 + 23,068) x 3.5% 263,876 Bonds Payable 23,876 Cash 240,000 c. The book value of the bonds on July 1, 20x8 is:

N I/Y PV PMT FV Enter 11 3.5 240000 8000000 Compute X =

7,639,938

The journal entry to record the conversion of the bonds is as follows:

Bonds payable ($7,639,938 x 31.25%*) $2,387,481Contributed Surplus – Conversion Rights ($433,765 x 31.25%) 135,552 Common Stock $2,523,033

* $2,500,000 / 8,000,000 = 31.25% Note that the market value of the shares is not relevant. d. Bonds payable ($8,000,000 – 2,500,000) $5,500,000 Cash $5,500,000 Contributed Surplus – Conversion Rights

($433,765 – 135,552) 298,213 Contributed Surplus 298,213 Problem 5 a. The proceeds that would have been received had the bonds not been convertible are:

N I/Y PV PMT FV Enter 20 3.3 350,000 10,000,000 Compute X =

10,289,462

The market value of the warrants is 60,000 warrants x $5.40 = $324,000 The allocation of proceeds to the warrants is: $10,597,000 - 10,289,462 = $307,538 The journal entry to record the issuance of the bonds is as follows:

Cash $10,597,000 Bonds payable $10,289,462 Contributed Surplus – Warrants 307,538

b. Cash (40,000 x $25) $1,000,000 Contributed Surplus – Warrants

$307,538 x 40,000 / 60,000 205,025 Common stock $1,205,025

Problem 6 SARS Liability Account - 20x1 Compensation expense: 1,200 - 60 - 150 = 990 x 50 x $18.50 x 1/3 $305,250 20x2 Cumulative compensation expense to end of

20x2: 1,200 - 60 - 90 - 100

= 950 x 50 x $20.60 x 2/3 $652,333 Less 20x1 compensation expense 305,250 347,083 652,333 20x3 Cumulative compensation expense to end of

20x2: 1,200 - 60 - 90 - 80 = 970 x 50 x $22.40 $1,086,400 Less 20x1 - 20x2 compensation expense 652,333 434,067 SARS Cashed Out: 320 x 50 x $23.50 (376,000) Re-measurement to market value at year-end Balance in account

= $652,333 + 434,067 - 376,000 710,400 Balance in account should be: 650 x 50 x $22.40 728,000 17,600 728,000 20x4 SARS Cashed Out: 450 x 50 x $20.50 (461,250) Re-measurement to market value at year-end Balance in account = $728,000 - 461,250 $266,750 Balance in account should be: 200 x 50 x $19.60 196,000 (70,750) 196,000 20x5 SARS Cashed Out: 200 x 50 x $18.20 (182,000) Re-measurement to market value at year-end (14,000) -0-

Journal Entries - 20x1 Compensation expense $305,250 SARS Provision $305,250 20x2 Compensation expense 347,083 SARS Provision 347,083 20x3 Compensation expense ($434,067 + 17,600) 451,667 SARS Provision 451,667 SARS Provision 376,000 Cash 376,000 20x4 SARS Provision 461,250 Cash 461,250 SARS Provision 70,750 Compensation expense 70,750 20x5 SARS Provision 182,000 Cash 182,000 SARS Provision 14,000 Compensation expense 14,000 Problem 7 a. FVTOCI investments $75,000 Cash $75,000 FVTPL Investments (Put Option Contract) 300 Cash 300 b. Loss on FVTOCI Investments (P&L) 20,000 FVTOCI investments (10,000 x 2.70) 20,000 FVTPL Investments (Put Option Contract) 21,700 Gain on FVTPL Investments ($22,000 – 300) 21,700

Problem 8 a. Jan 2, 20x3 Cash $50,000,000 Bonds payable $50,000,000 b. Dec 31, 20x3 Interest expense 3,100,000 Cash 3,100,000 Interest paid to bondholders = $50,000,000 x 6.2% Interest expense 650,000 Cash 650,000 Cash payment to swap partner = $50,000,000 x 1.3%

= $650,000 OCI 80,000 FVTL Investments (Swap) 80,000 c. Dec 31, 20x3 Interest expense 4,350,000 Cash 4,350,000 Interest paid to bondholders = $50,000,000 x 8.7% Cash 600,000 Interest expense 600,000 Cash receipt from swap partner = $50,000,000 x 1.2%

= $600,000 FVTL Investments (Swap) 90,000 OCI 90,000

Problem 9 (a) Cash $10,800,000 Bonds Payable $8,500,000 Contributed Surplus – Conversion Rights 2,300,000 The semi-annual YTM in the date the bonds are issued is: N = 40 PV = 8,500,000 PMT = -400,000 FV = -10,000,000 Solve for I = 4.857% (b) Book Value of Bonds Payable on Jan 1, 20x9: N = 36 I = 4.857 PMT = 400,000 FV = 10,000,000 Solve for PV = $8,555,503 Bonds Payable ($8,555,503 x 30%) 2,566,651 Contributed Surplus – Conversion Rights (2,300,000 x 30%) 690,000 Common Stock 3,156,651 (c) Number of bonds converted = $10,000,000 / 1,000 x 30% = 3,000 Number of shares = 3,000 x 5 shares x 2 = 30,000 (d) Advantages: • No obligation (or more flexibility) to pay dividends, as opposed to fixed cash

outflows for interest payments • No obligation to repay principal at maturity date of bonds • Increased income from reduced interest costs • Positive effect on debt to equity ratio Disadvantages: • Dilution of share price for existing shareholders • Existing shareholders will pressure the company not to dilute their ownership

and power to vote

Problem 10 (a) FVTPL Investments (Call options) $200 Cash $200 (b) FVTPL Investments (Call options) 13,000 Gain on FVTPL Investments 13,000 (c) The gain increases profit for the period by $13,000 (d) Jones has used the option for speculative purposes. Jones is not hedging to

minimize the risk of a current or future transaction Problem 11 Dec 31, 2009 Compensation expense $213,750 Contributed Surplus – SO $213,750 $450,000 / 2 years x 95% Dec 31, 2010 Compensation expense 208,125 Contributed Surplus – SO 208,125 Total actual compensation expense: $450,000 x 30,000 / 32,000 $421,875 Less compensation expense accrued

to the end of 2009

(213,750) $208,125 Jan 3, 2011 Cash (20,000 x $40) 800,000 Contributed Surplus – SO

(421,875 x 20/30)

281,250 Common Stock 1,081,250 May 1, 2011 Cash (10,000 x $40) 400,000 Contributed Surplus – SO

(421,875 x 10/30)

140,625 Common Stock 540,625

Problem 12 (a) PV of the notes: N = 5, I = 12, FV = $1,200,000 Solve for PV = $680,912 Cash $1,000,000 Note payable $680,912 Contributed Surplus - Warrants 319,088 (b)

InterestCarrying

Amount Jan 1, 20x8 $680,912 Dec 31, 20x8: $680,912 x 12% $81,709 762,621 Dec 31, 20x9: $762,621 x 12% 91,515 854,136 Dec 31, 20x10: $854,136 x 12% 102,496 956,632 Dec 31, 20x11: $956,632 x 12% 114,796 1,071,428 Dec 31, 20x12: $1,071,428 x 12% 128,572 1,200,000 (c) Interest expense 81,709 Note payable 81,709

Problem 13 (a) Dec 31, 20x7 Cash $10,000,000 Loan payable $10,000,000 Jun 30, 20x8 Interest expense 350,000 Cash 350,000 $10,000,000 x 7% x 1/2 Interest expense 50,000 Cash 50,000 $10,000,000 x (8% - 7%) x 1/2 OCI 200,000 FVTPL Investments (Swap) 200,000 Dec 31, 20x8 Interest expense 375,000 Cash 375,000 $10,000,000 x 7.5% x ½ Interest expense 25,000 Cash 25,000 $10,000,000 x (8% - 7.5%) x 1/2 FVTPL Investments (Swap) 260,000 OCI 260,000 (b) Balance Sheet (Dec 31, 20x7) Long-term liabilities Loan payable $10,000,000

(c) Balance Sheet (June 30, 20x8) Current liabilities FVTPL Investments (Swap) $200,000 Long-term liabilities Loan payable $10,000,000 Shareholders’ Equity OCI (Swap Agreement) $200,000 dr. Statement of Comprehensive Income

(6 month period ending June 30, 20x8) Profit and Loss Interest expense $400,000 OCI Loss on Swap Agreement 200,000 (d) Balance Sheet (December 31, 20x8) Current assets Swap contract $60,000 Long-term liabilities Loan payable $10,000,000 Shareholders’ Equity OCI (Swap Agreement) $60,000 cr. Income Statement (year ending December 31, 2008) Profit and loss Interest expense $800,000 OCI Gain on Swap Agreement $260,000

BUSI 2002 – Intermediate Accounting II Chapter 17 – Earnings Per Share Additional Problems with Solutions Problem 1 The December 31, 20x2 Statement of Financial Position of Davis Company included the following items: • 4,000 9% convertible bonds outstanding. The 20-year bonds mature December 31, 20x5. Each $1,000

bond is convertible into 30 common shares. • 270,000 convertible, cumulative, preferred shares. These preferred shares have an annual dividend of

$2.00 per share and each preferred share can be exchanged for 3 common shares. • 1,500,000 common shares issued and outstanding. • 125,000 Series 1 share options outstanding with an exercise price of $45. • 100,000 Series 2 share options outstanding with an exercise price of $60. During 20x2, the following occurred: • Net income was $4,000,000. • On June 1, 20x2, Davis issued 150,000 new common shares for cash • The dividends on the preferred shares were paid on June 30, 20x2. • A $0.25 per share dividend was paid to common shareholders (date of record was April 15) on April 30,

20x2. • The tax rate for the year was 40%. • The market value of the common shares averaged $50 for the year. Required - a) Compute basic and diluted earnings per common share for 20x2. Show your calculations. b) Assume that on Nov 31, 20x2, Davis issued a 10% stock dividend to common shareholders. Calculate

the weighted average number of common shares for purposes of calculation of basic earnings per share.

Problem 2 The following data is available for the Culum Company for it’s 20x4 fiscal year. • Net income for the year ended December 31, 20x4 amounted to $1,650,000. • the Culum company had 1,500,000 common shares outstanding at January 1, 20x4. • The following share issues took place: March 31 100,000 shares @ $15.67 per share November 1 200,000 shares @ $17.60 per share • On May 18, the company declared a 10% stock dividend. • the Company has $1,000,000 of convertible, cumulative preferred shares outstanding. These shares pay

a dividend of 6%. The last time a preferred share dividend was paid was on December 31, 20x1. Each $1,000 par value preferred share converts into 120 common shares

• the company also has $3,000,000 of convertible bonds outstanding. These bonds were issued at par

when the market interest rates were 7%. The bonds pay interest semi-annually. Each $1,000 bond is convertible into 50 common shares.

• there are 60,000 stock options outstanding that expire on July 16, 20x8. The holder of the stock options

can purchase a share of stock for $7.50. • the average market price of the shares for 20x4 was $16.00. • the tax rate is 40%. Required – Compute the basic and diluted earnings per share.

Problem 3 Jamie McLeod, controller at Munroe Pharmaceutical Industries, a public company, is currently preparing the calculation for basic and diluted earnings per share and the related disclosure for Munroe’s external financial statements. Below is selected financial information for the fiscal year ended June 30, 20x2.

MUNROE PHARMACEUTICAL INDUSTRIES Selected Statement of Financial Position Information

June 30, 20x2 Long-term debt Notes payable, 10% $ 1,000,000 8%, $5,000,000, semi-annual convertible bonds payable 4,458,112 10% bonds payable 6,000,000 Shareholders’ equity Preferred Shares, no par, $4.25 cumulative, 100,000 shares authorized, 25,000 shares issued and outstanding $ 1,250,000 Common Shares, unlimited number of shares authorized, 1,000,000 shares issued and outstanding 4,500,000 Contributed Surplus 500,000 Retained earnings 6,000,000 The following transactions have also occurred at Munroe. 1. Options were granted in 20x0 to purchase 100,000 shares at $15 per share. Although no options were

exercised during 20x2, the average price per common share during fiscal year 20x2 was $20 per share. 2. The 8% convertible bonds are convertible into common shares at 50 shares per $1,000 bond. They are

exercisable at any time and were issued on July 2, 20x0 when the market interest rate was 10%. The bonds mature on July 2, 20x10.

3. The $4.25 preferred shares was issued in 20x0. 4. There are no preferred dividends in arrears; however, preferred dividends were not declared in fiscal

year 20x2. 5. On October 1, 20x1, Munroe issued 200,000 common shares. 6. Net income for fiscal year 20x2 was $1.5 million, and the average income tax rate is 40%. Required – For the fiscal year ended June 30, 20x2, calculate Monroe Pharmaceutical Industries’: (a) basic earnings per share (b) diluted earnings per share

Problem 4 Marion Tess, controller, at Norris Pharmaceutical Industries, a public company, is currently preparing the calculation for basic and fully diluted earnings per share and the related disclosure for Norris' external financial statements. Below is selected financial information for the fiscal year ended June 30, 20x2. Norris Pharmaceutical Industries Selected Statement of Financial Position Information June 30, 20x2 Long-term debt Notes payable, 10% $ 1,000,000 7% convertible bonds payable 5,000,000 10% bonds payable 6,000,000 Total long-term debt $12,000,000 Shareholders' equity Preferred stock, 8.5% cumulative, $50 par value, 100,000 shares authorized, 25,000 shares issued and outstanding $ 1,250,000Common stock, $1 par, 10,000,000 shares authorized. 1,000,000 shares issued and outstanding 1,000,000Additional paid-in capital 4,000,000Retained earnings 6,000,000 Total shareholders' equity $12,250,000 The following transactions have also occurred at Norris. Options were granted in 20x0 to purchase 100,000 shares at $15 per share. Although no options were

exercised during 20x2, the average price per common share during fiscal year 20x2 was $20 per share, while the market price on June 30, 20x2, was $25 per common share.

Each bond was issued at face value. The 7% convertible debenture will convert into common stock at 50

shares per $1,000 bond. They are exercisable after five years. The 8.5% preferred stock was issued in 20x0. There are no preferred dividends in arrears; however, preferred dividends were not declared in fiscal year

20x2. The 1,000,000 shares of common stock were outstanding for the entire 20x2 fiscal year. Net income for fiscal year 20x2 was $1,500,000, and the average income tax rate is 40%. Required - a. For the fiscal year ended June 30, 20x2, calculate Norris Pharmaceutical Industries'

1. basic earnings per share. 2. diluted earnings per share.

b. Describe the appropriate disclosure required for earnings per share for Norris Pharmaceutical Industries for the fiscal year ended June 30, 20x2.

Problem 5 Rivera Ltd. reported net income of $13,500,000 for the year ended December 31, 20x5. The following information is available: • there were 3,000,000 common shares outstanding at December 31, 20x5 • the company has a convertible bond issue outstanding with the following characteristics:

Face Value $10,000,000Coupon Rate 5.6%Yield to maturity on date of issue 4.8%Interest payment dates June 30 and Dec 31Bonds mature on June 30, 20x12 Bond conversion ratio – each $1,000 bond is convertible into 40 common shares.

• the company has a convertible, cumulative preferred share issue of $25,000,000 paying a dividend of

5%. There are 100,000 shares outstanding. The conversion ratio is 2 common shares for each preferred share. As at December 31, 20x5, the preferred dividends are in arrears 3 years.

• also outstanding are 200,000 noncumulative preferred shares in the amount of $10,000,000. The stated

dividend on these preferred shares is 7%. The dividends on these shares were declared in 20x5. • the following common share transactions took place during the year:

April 1 – Issue 200,000 shares June 1 – 2:1 split October 1 – Shares retired and cancelled 50,000 shares

• the company has two series of stock options outstanding:

- Series G: 200,000 options, exercise price $12 - Series H: 150,000 options, exercise price $22

• the average market price of the company’s stock in 20x5 was $18 • the tax rate is 40% • all convertible share conversion ratios are adjusted in the case of a stock split or stock dividend. Required – Calculate all relevant EPS numbers for the year ended December 31, 20x5. Problem 6 On June 1, 20x6, Mowbray Corp. and Surrey Limited merged to form Lancaster Inc. A total of 800,000 shares were issued to complete the merger. The new corporation uses the calendar year as its fiscal year. On April 1, 20x8, the company issued an additional 400,000 shares for cash. All 1.2 million shares were outstanding on December 31, 20x8. Lancaster Inc. also issued $600,000 of 20-year, 8% convertible bonds at par on July 1, 20x8. Each $1,000 bond converts to 40 shares of common at any interest date. None of the bonds have been convened to date. If the bonds had been issued without the conversion feature, the annual interest rate would have been 10%.

Lancaster Inc. is preparing its annual report for the fiscal year ending December 31, 20x8. The annual report will show earnings per share figures based on a reported after-tax net income of $1,540,000 (the tax rate is 40%). Required - Calculate: 1. Basic earnings per share. 2. Diluted earnings per share.

Problem 7 The following information is for Prancer Limited for 20x8: Net income for the year $2,200,000 8% convertible bonds issued at par ($1,000 per bond), with each bond convertible into 30 common shares 1,000,000 6% convertible, cumulative preferred shares, $100 par value, with each share convertible into 3 common shares 3,000,000 Common shares (600,000 shares outstanding) 6,000,000 Stock options (granted in a prior year) to purchase 50,000 common shares at $20 per share 500,000 Tax rate for 20x8 42% Average market price of common shares $27 per share There were no changes during 20x8 in the number of common shares, preferred shares, or convertible bonds outstanding. For simplicity, ignore the requirement to book the convertible bonds' equity portion separately. Required - (a) Calculate basic earnings per share for 2008. (b) Calculate diluted earnings per share for 2008.

SOLUTIONS Problem 1 a) Weighted Average # of Common Shares –

Common Shares outstanding at beginning of year 1,500,000 – 150,000 1,350,000June 1 Issue: 150,000 x 7/12 87,500 1,437,500 Basic EPS = ($4,000,000 – 540,000) / 1,437,500 = $2.41 Effect of Dilution: Convertible bonds: Increase in numerator: $4,000,000 x 9% x .6 = $216,000 Increase in denominator: 4,000 x 30 = 120,000 Incremental impact = $216,000 / 120,000 = $1.80 Preferred Shares: $540,000 / 810,000 = $0.67 Series 1 share options: Free shares = 125,000 - 125,000 x $45 / 50 = 125,000 – 112,500 = 12,500 Series 2 share options are out of the money and therefore antidilutive. Numerator Denominator EPSBasic EPS $3,460,000 1,437,500 $2.41Series 1 share options 12,500 $3,460,000 1,450,000 2.39Preferred shares 540,000 810,000Diluted EPS $4,000,000 2,260,000 $1.77

Convertible bonds are not included since they would have an antidilutive effect. b) Common Shares outstanding at beginning of year

(1,500,000 / 1.1) – 150,000 1,213,636 June 1 Issue: 150,000 x 7/12 87,500 Nov 31 Stock Dividend: 1,213,636 x 10% 121,364 87,500 x 10% 8,750 1,431,250

Problem 2 Basic EPS Calculations - Weighted average number of common shares - Shares outstanding at beginning of year 1,500,000 March 31 issue: 100,000 x 9/12 75,000 May 18 stock dividend – 1,575,000 x 10% 157,500 November 1 issue: 200,000 x 2/12 33,333 1,765,833 Basic EPS = (1,650,000 – 60,000) / 1,765,833 = 1,590,000 / 1,765,833 = 0.90 Diluted EPS Calculations - Impact of preferred shares: 60,000 / (1,000,000 / 1,000 x 120 x 1.1) = 60,000 / 132,000 = $0.45 Impact of convertible bonds: = ($3,000,000 x 7% x .6) / (3,000,000 / 1,000 x 50 x 1.1) = $126,000 / 165,000 = $0.76 Impact of options: [60,000 – (60,000 x $7.50 / 16)] x 1.1 = (60,000 – 28,125) x 1.1 = 35,063 Order of entry: options, preferred shares, bonds Numerator Denominator EPS

Basic EPS $1,590,000 1,765,833 $0.90 Options 35,063 1,590,000 1,800,896 0.88 Preferred shares 60,000 132,000 1,650,000 1,932,896 0.85 Convertible bonds 126,000 165,000

Diluted EPS $1,776,000 2,097,896 $0.85

Problem 3 (a) Weighted average number of common shares - Number of common shares – beginning of year 800,000 Oct 1, 20x1: 200,000 x 9/12 150,000 950,000 Preferred share dividend = 25,000 shares x $4.25 = 106,250 Basic EPS = ($1,500,0000 – 106,250) / 950,000 = $1.47 (b) Book value of convertible bonds as at July 1, 20x1: N = 18, I = 5, PMT = 200000, FV = 5,000,000 Solve for PV = $4,415,521 Interest expense on convertible bonds for the year ended June 30, 20x2: 1st half: $4,415,521 x 5% $220,776 2nd half: ($4,415,521 + 20,776 Amortization of Discount) x 5% 221,815 Impact of convertible bonds: Numerator = ($220,776 + 221,815) x 0.6 = $265,554 Denominator = $5,000,000 / 1,000 x 50 = 250,000 $265,554 / 250,000 = $1.06 Impact of options: Free shares = 100,000 - (100,000 x 15 / 20) = 25,000 Order of entry: Options, Bonds Numerator Denominator EPS Basic $1,393,750 950,000 $1.47 Options 25,000 1,393,750 975,000 $1.43 Bonds 265,554 250,000 $1,659,304 1,225,000 $1.35

Problem 4 a. Basic EPS = $1,500,000 - 106,2501 / 1,000,000 = $1,393,750 / 1,000,000 = $1.39 1 25,000 shares x $50 x 8.5% Fully Diluted EPS:

Incremental impact of the exercise of options: Number of shares assumed purchased: 100,000 x $15 = $1,500,000 / $20 = 75,000 Increase in shares (free shares): 100,000 – 75,000 = 25,000 Incremental impact of the exercise of bonds: Increase in income = $5,000,000 x 7% x .6 = $210,000 Increase in shares = $5,000,000/1,000 x 50 = 250,000 Incremental impact = $0.84 Numerator Denominator EPS Basic EPS $1,393,750 1,000,000 $1.39 Options 25,000 $1,393,750 1,025,000 $1.36 Convertible Bonds 210,000 250,000 1,603,750 1,275,000 $1.26 b. Norris Pharmaceutical Industries should disclose both basic earnings per share and fully diluted earnings

per share on the face of the income Statement for all periods presented.

Problem 5 Basic EPS Calculations Weighted Average Number of Shares – # of shares outstanding at beginning of year: [(3,000,000 + 50,000) / 2] – 200,000 = 1,325,000

Shares outstanding at beginning of year 1,325,000Apr 1 issue: 200,000 x 9/12 150,000Jun 1 Stock Split: 1,325,000 + (200,000 x 9/12) 1,475,000Oct 1 retirement: 50,000 shares x 3/12 (12,500)Weighted average number of common shares 2,937,500

Preferred Dividends Cumulative preferred shares: $25,000,000 x 5% $1,250,000 Declared dividends on non-cumulative preferred shares: $10,000,000 x 7% 700,000 $1,950,000 Basic EPS = ($13,500,000 – 1,950,000) / 2,937,500 = $11,550,000 / 2,937,500 = $3.93 Diluted EPS Incremental impact of convertible bonds:

Book value of bonds, Jan 1, 20x5: N = 15, I = 2.4, PMT = 280,000, FV = 10,000,000, Solve for PV = $10,498,918

Book value of bonds, December 31 20x5: N = 13, I = 2.4, PMT = 280,000, FV = 10,000,000, Solve for PV = $10,442,193

Amortization of premium, 20x5: $10,498,918 – 10,442,193 = 56,725

Interest expense = ($280,000 x 2) – 56,725 = $503,275 Incremental impact = ($503,275 x 0.6) / (10,000,000/1,000 x 40 x 2) = 301,965 / 800,000 = 0.38

Incremental impact of preferred shares: $1,250,000 / (100,000 x 2 x 2) = $1,250,000 / 400,000 = $3.125 Impact of Options Series G options: 200,000 – (200,000 x 12 / 18) = 66,667 x 2 = 133,334 Series H options are out of the money and therefore antidilutive. Calculation of Diluted EPS – Numerator Denominator EPSBasic EPS $11,550,000 2,937,500 $3.93Options 133,334 11,550,000 3,070,834 $3.76Bonds 301,965 800,000 $11,851,965 3,870,834 $3.06 Preferred shares are excluded because they are antidilutive. Diluted EPS = $3.06

Problem 6 1. Weighted average # of common shares = 800,000 + 400,000 (9/12) = 1,100,000 Basic EPS =$1,540,000 / 1,100,000 = $1.40 2. Incremental impact of bonds = Increase in numerator = ($24,852* x 0.60) = $14,911 Increase in denominator = $600,000 / 1,000 x 40 = 24,000 x ½ = 12,000 $14,911 / 12,000 = $1.24 => Dilutive * Interest expense: N = 40, I = 5, PMT = 24,000, FV = 600,000 Solve for PV = $497,045 Interest expense = $497,045 x 5% = $24,852 Diluted EPS = ($1,540,000 + 14,911) / (1,100,000 + 12,000) = $1,554,911 / 1,112,000 = $1.40

Problem 7 (a) Basic EPS = ($2,200,000 – 180,000) / 600,000 = $2,020,000 / 600,000 = $3.37 (b) Impact of conversion of bonds - (1,000,000 x 8% x .58) / (1,000,000 / 1,000 x 30) = $46,400 / 30,000 = $1.55 => Dilutive Impact of conversion of preferred shares - 180,000 / (30,000 x 3) = 180,000 / 90,000 = $2.00 => Dilutive Impact of conversion of options - 50,000 - (50,000 x $20 / 27) = 12,963 increase in denominator Order of entry: Options, Bonds, Preferred Shares Numerator Denominator EPS

Basic EPS $2,020,000 600,000 $3.37 Options 12,963 2,020,000 612,963 $3.30 Bonds 46,400 30,000 2,066,400 642,963 $3.21 Preferred shares 180,000 90,000

2,246,400 732,963 $3.06 Fully diluted EPS = $3.06

BUSI 2002 – Intermediate Accounting II Chapter 18 – Accounting for Income Taxes Additional Problems with Solutions Note – Unless you are told otherwise, assume all companies are publicly accountable. Problem 1 Assume that the Clarke Company has the following information available as at December 31, 20x2.

Net book value of fixed assets $1,706,240 Undepreciated Capital Cost Class 1 (4%) 629,450 Class 8 (20%) 340,000 Class 10 (30%) 175,210 $1,144,660 Warranty liability $60,000Accrued pension liability $200,000Non-capital loss carryforwards (incurred in 20x2) $280,000 Tax Rate 35%

You are given the following information for the year ended December 31, 20x3: Net income before taxes $1,200,000Depreciation expense 180,000Warranty expense 140,000Warranty costs incurred 125,000Pension expense 75,000Amount paid to pension plan trustee 100,000Club dues 6,000Entertainment expenses 20,000Equity income 80,000 Capital Asset Additions: Class 8 $40,000 Class 10 20,000

Capital Asset Disposals Class 8: Proceeds 20,000 Net book value of assets sold 25,000 Class 10: Proceeds 15,000 Net book value of assets sold 6,000 Original cost of asset sold 30,000 Tax rate (enacted at the end of 20x3) 33% Calculate the income tax expense as it would appear on the income statement. Problem 2 The controller of Carstwell Manufacturing Ltd. was finalizing the company's financial statements for the year ended December 31, 20x1. He had determined that financial statement income before income taxes was $235,000, a dramatic improvement over the prior year when the company had suffered a loss. For fiscal 20x0, the company had recorded a net loss of $80,000 for both accounting and tax purposes. No refund of previous years' taxes paid has been claimed by Carstwell. The company felt that it was probable that the loss would be used within the allowable period, so they recognized the deferred benefit of the tax loss for accounting purposes. The controller reviewed some of the notes he had made to himself in preparing the financial statements up to this point. The notes were as follows: 1) The company had deducted $200,000 of depreciation for 20x1. For tax purposes, the company had recorded

$300,000 in capital cost allowance. 2) For the first time in its history, the company had recorded warranty expense for products sold. At the end of

fiscal 20x1, the liabilities included an accrual of $40,000 for warranties. 3) The company sold a depreciable asset for proceeds of $25,000. The net book value of the asset was $30,000. 4) The company pays tax at the rate of 45%. This rate was in effect last year and is not expected to change. 5) The balance in the deferred income tax account amounted to a credit of $121,500 and was classified as

follows on the Statement of Financial Position as at December 31, 20x0: Long-term Assets Deferred Income Taxes $36,000 Long-term Liabilities Deferred Income Taxes $157,500

Required: Prepare the lower portion of the company's income statement beginning with "Income before taxes." Show current and deferred tax expense separately. Problem 3 Chive Ltd.'s income of $700,000 before income taxes for the year ended March 31, 20x1, includes the following items: Some equipment was disposed of during the year for $192,500. The net book value of these items at the

time of the sale was $70,000 and the original cost was $225,000. Dividends received from a taxable Canadian corporation during the year totaled $35,000.

Capital cost allowance claimed amounted to $245,000 and the company pays income tax at a rate of 50%. Provision for warranty repairs for the year was $70,000 while depreciation expense for the same period

amounted to $157,500. Chive Ltd. paid a $3,500 interest penalty for late federal income tax installments. Up to the fiscal year ended March 31, 20x0, the company's temporary difference, and hence, deferred income tax balance, resulted only from its purchase of depreciable assets, the net book value and undepreciated capital cost of which, at the end of that year were $1,575,000 and $1,330,000 respectively. Required - Calculate the taxable income and the balance in the deferred income tax account at March 31, 20x1. Prepare the journal entries to record the provision for income taxes.

Problem 4 The following is an extract from the accounting records of Cinnamon Ltd.: 20x2 20x1 20x0Accounting income $232,500 $(170,500) $155,000Depreciation expense 77,500 77,500 77,500Capital cost allowance claimed 116,250 NIL 120,500 The company's fiscal year end is December 31. There was a credit balance in the deferred income tax account at January 1, 20x0, in the amount of $186,000. This amount was based on a tax rate of 42%. Cinnamon Ltd. 's income tax rate was also 42% in 20x0, 20x1 and 20x2. Required - a) Prepare the journal entries to record income taxes for 20x0, 20x1 and 20x2. Show all calculations. b) Prepare a partial income statement for 20x1. c) What is the balance in the DIT Account at the end of 20x2? Problem 5 Crandall Corporation was formed in 20xl . Relevant information pertaining to 20xl, 20x2 and 20x3 are as follows: 20xl 20x2 20x3 Net income before income tax $ 100,000 $ 100,000 $ 100,000 Accounting income includes the following: Depreciation (assets have a cost of $120,000) 10,000 10,000 12,000 Pension expense 5,000 7,000 10,000 Warranty expense 3,000 3.000 3,000 Dividend income 2,000 2,000 3,000 Taxable income includes the following: Capital cost allowance 25,000 15,000 7,000 Pension funding (amount paid) 7,000 8,000 9,000 Warranty costs 1,000 4,000 3,000 Tax rate - enacted in each year 40% 44% 48% Required Prepare the journal entry to record the income tax expense for each year. Problem 6 Homer Company had the following deferred tax amounts at the beginning of the year 20x0: • Deferred income tax asset - (associated with warranties) of $10,000 • Deferred income tax liability - (associated with depreciation) of $250,000

Information related to the year 20x0 was as follows:

Accounting income before tax $ 1,000,000

Items included in arriving at income before tax: Entertainment expense $ 25,000 Dividends received from a Canadian corporation 70,000 Depreciation expense 300,000 Warranty expense 50,000

Additional information: Capital cost allowance $ 400,000 Warranty costs paid 30,000

In the March 20x0 budget speech, the Finance Minister regretfully stated that he was forced to raise the income tax rate for the year 20x1 and later years to 45%. This was a sad surprise to Canadians since the income tax rate had been 40%. The intended change was enacted into law in November 20x0. Required Calculate (i) the income tax expense for the year 20x0 and (ii) the deferred tax amounts as they would appear on the Statement of Financial Position as at December 31, 20x0 (include both IFRS and ASPE presentations) Problem 7 The accounting records of Geoff Corp, a real estate developer, indicated income before taxes and discontinued operations of $850,000 for its year ended December 31, 20x5 and $525,000 for the year ended December 31, 20x6. The following additional data are available. 1. Geoff Corp. pays an annual life insurance premium of $9,000 covering the top management team. The

company is the named beneficiary in each case. Life insurance premiums are not deductible. 2. The net book value of the company's property, plant, and equipment at January 1, 20x5 was $1,256,000,

and the UCC at that date was $998,000. Geoff recorded depreciation expense of $175,000 and $180,000 in 20x5 and 20x6, respectively.

All assets are in one class for CCA purposes and are subject to a 20% CCA rate. The company disposed of one asset in each of 20x5 and 20x6. Details with regards to the assets disposed and additions is as follows:

Disposals Year

Original Cost

Net Book Value

Proceeds

Additions

20x5 $80,000 $50,000 $60,000 $250,00020x6 120,000 80,000 50,000 180,000

3. Geoff deducted $211,000 as a restructuring charge in determining income for 20x4. At December 31,

20x4, an accrued liability of $199,500 remained outstanding relative to the restructuring. This expense is deductible for tax purposes, but only as the actual costs are incurred and paid for. As the actual restructuring of operations took place in 20x5 and 20x6, the liability was reduced to $68,000 at the end of 20x5 and $0 at the end of 20x6.

4. In 20x5, property held for development was sold and a profit of $52,000 was recognized in income. Because the sale was made with delayed payment terms, the profit is taxable only as Geoff receives payment from the purchaser. A 10% down payment was received in 20x5, with the remaining 90% expected in equal amounts over the following three years.

5. Nontaxable dividends of $2,250 were received from taxable Canadian corporations in 20x5, and $2,750

in 20x6. 6. In addition to the income before taxes identified above, Geoff reported a before-tax gain on discontinued

operations of $18,800 in 20x5. 7. The tax rate to the end of 20x5 was 30%. The tax rate for the year 20x6 onwards is 32%. This change in

tax rate was not known in 20x5. Required - (a) Determine the balance of any deferred income tax asset or liability account at December 31, 20x4. (b) Determine 20x5 and 20x6 taxable income. (c) Prepare the journal entries to record current and deferred income tax expense for 20x5 and 20x6. (d) Identify how the deferred income tax asset or liability account(s) will be reported on the December 31,

20x5 and 20x6 Statement of Financial Positions under both IFRS and ASPE.

Problem 8 Reno Ltd., in the first year of its operations, reported the following information regarding its operations: a. Income before tax for the year was $1,300,000 and the tax rate was 35%. b. Depreciation was $140,000 and CCA was $67,000. Net book value at year-end was $820,000, while

UCC was $893,000. c. The warranty program generated an estimated cost (expense) on the income statement of $357,000 but

the cash paid out was $264,000. The $93,000 liability resulting from this was shown as a current liability. On the income tax return, the cash paid is the amount deductible.

d. Entertainment expenses of $42,000 were included in the income statement but were not allowed to be deducted for tax purposes.

e. Franchise fee revenues of $90,000 were received. The company amortized the franchise fees over the life of the franchise of 10 years. For tax purposes, the franchise fees are taxable when received.

f. The company recorded a pension expense of $60,000 and made payments to the pension plan trustee of $20,000

In the second year of its operations, Reno Ltd. reported the following information: g. Income before income tax for the year was $1,550,000 and the tax rate was 37%. h. Assets whose original cost was $100,000 were sold for $60,000. The net book

value of these assets was $85,000. i. Depreciation was $140,000 and the CCA was $370,000. Net book value at year end was $595,000,

while UCC, was $463,000. j. The estimated costs of the warranty program were $387,000 and the cash paid out was $342,000. The

liability had a balance of $138,000. k. The company received dividends of $75,000 from another Canadian Company. The investment is

accounted for using the cost method. l. The company recorded a pension expense of $75,000 and made payments to the pension plan trustee of

$200,000 Required - Calculate tax expense, any related Statement of Financial Position amounts for both years. Prepare the journal entries for both years.

Problem 9 Samuels Holding Inc. owns commercial property consisting mainly of strip malls that generate rental revenue. Due to a shift in retail customers' shopping trends, Samuels entered into inducement agreements with its existing and new tenants for the first time in 20x9. Samuels's objective in offering inducements is to secure lease rates that are slightly higher than the market rate for terms of a minimum of three years. Samuels offered rent-free periods of up to six months to tenants to induce them to sign new leases or renew existing leases for its properties. Samuels's accounting policy related to the rent-free periods consists of allocating the revenue from the leases evenly over all months of the lease. For tax purposes, Samuels is allowed to use the cash basis. By using the cash basis for tax purposes, Samuels can postpone the tax related to the rent revenue. For financial reporting purposes, the rent revenue is accrued during the rent-free periods in an account called Rent Recoverable. Following the rent-free period, the Rent Recoverable account is amortized to Rent Revenue over the remaining term of each lease. Samuels's lease agreements also call for the tenants to make quarterly rental payments three months in advance. These rental payments are initially recorded as unearned rent revenue for accounting purposes. The CRA requires that Samuels report the rental revenue in the accounting period in which the rent is collected. During the fiscal year ending December 3 1, 20x9, Samuels paid pollution fines and interest on late and deficient income tax instalments, and received non-taxable dividends. At December 31, 20x9, Samuels had the following balances for the accounts related to the information above: Rent Recoverable (assume non-current classification) $440,000Unearned Rent Revenue (assume current classification and no balance at Dec. 31, 20x8) 360,000 Dividend Income 15,000 Fines Expense (non-tax deductible) 34,000 Tax Instalment Interest Expense (non-tax deductible) 4,000 Samuels's tax rate is 42% for 20x9 and 40% for subsequent years. Income before income tax for the year ended December 31, 20x9, was $1,140,000. Required – (a) Calculate the future income tax asset or liability balances at December 31, 20x9. (b) Calculate taxable income and income taxes payable for 20x9. (c) Prepare the journal entries to record income taxes for 20x9. (d) Prepare the income statement for 20x9, beginning with the line "Income before

income taxes." (e) Provide the balance sheet disclosure for any resulting future tax balance sheet accounts at December 31,

20x9. Be specific about the classification. Problem 10 Refer to Problem 9 for Samuels Holding Inc., and assume the same facts for the fiscal year ending December 31, 20x9. During the next year of operations, 20x10, Samuels continued to offer rent-free periods to its tenants as an inducement to renew or sign new leases for its rental properties. The balances for the accounts related to its rental operations and for the payments for interest on late and deficient tax instalments, and the balance for

non-taxable dividend income for the year ending December 31, 20x10 follow (balances at December 31, 20x9, are also listed): 20x10 20x9Rent Recoverable (assume non-current classification) $350,000 $440,000 Unearned Rent Revenue (assume current classification) 410,000 360,000 Dividend Income 20,000 15,000 Fines Expense - 34,000 Tax Instalment Interest Expense 6,000 4,000 Samuels's tax rate is 40% for 20x10 and subsequent years. Income before income tax for the year ended December 31, 20x10 was $1.28 million. Required - (a) Calculate the future income tax asset or liability balances at December 31, 20x10 (b) Calculate taxable income and income taxes payable for 20x10. (c) Prepare the journal entries to record income taxes for 20x10. (d) Prepare a comparative income statement for 20x9 and 20x10, beginning with the l

line "Income before income taxes." (e) Provide the comparative balance sheet disclosure for any resulting future tax alance sheet accounts at

December 31, 20x9 and 20x10. Be specific about the classification.

Problem 11 Spumoni Inc. reports the following pre-tax incomes (losses) for both financial reporting purposes and tax purposes:

Year Accounting Income (Loss) Tax Rate 20x6 $ 120,000 34% 20x7 90,000 34% 20x8 $(280,000) 38% 20x9 220,000 38%

The tax rates listed were all enacted by the beginning of 20x6. Required - (a) Prepare the journal entries for each of the years 20x6 to 20x9 to record income taxes, assuming the tax

loss is first carried back, and that at the end of 2008, the loss carryforward benefits are judged more likely than not to be realized in the future.

(b) Using the assumption as in (a), prepare the income tax section of the 20x8 and 20x9 income statements, beginning with the line "Income (loss) before income taxes."

Problem 12 Lafleur Corp. reported the following differences between balance sheet carrying amounts arid tax values at December 31, 20x7: Book Value Tax ValueDepreciable assets $125,000 $93,000 Warranty liability (current liability) 18,500 0 Pension funded status liability (long-term liability) 34,600 0 The differences between the carrying amounts and tax values were expected to reverse as follows: 20x8 20x9 After 20x9Depreciable assets $17,500 $12,500 $2,000Warranty liability 18,500 0 0Pension funded status liability 11,000 11,000 12,600 Tax rates enacted at December 31, 20x7 were 31% for 20x7, 30% for 20x8, 29% for 20x9, and 28% for 20x10 and later years. During 20x8, Lafleur made four quarterly tax instalment payments of $8,000 each and reported income before taxes on its income statement of $109,400. Included in this amount were dividends from taxable Canadian corporations of $4,300 (non-taxable income) and $20,000 of expenses related to the executive team's golf dues (non-tax-deductible expenses). There were no changes to the enacted tax rates during the year. As expected, book depreciation in 20x8 exceeded the capital cost allowance claimed for tax purposes by $17,500, and there were no additions or disposals of property, plant, and equipment during the year. A review of the 20x8 activity in the warranty liability account in the ledger indicated the following:

Balance, Dec. 31, 20x7 $ 18,500 Payments on 20x7 product warranties (18,900) Payments on 20x8 product warranties (5,600) 20x8 warranty accrual 28,300 Balance, Dec. 31, 20x8 $22,300

All warranties are valid for one year only. The pension funded status liability account reported the following activity:

Balance, Dec. 31, 20x7 $34,600Payment to pension trustee (70,000)20x8 pension expense 59,000Balance, Dec. 31, 20x8 $23,600

Pension expenses are deductible for tax purposes, but only as they are paid to the trustee, not as they are accrued for financial reporting purposes. Required - (a) Calculate the deferred tax asset or liability account at December 31, 20x7, and explain how it should be

reported on the December 31, 20x7 balance sheet. (b) Calculate the deferred tax asset or liability account at December 31, 20x8.

(c) Prepare all 20x8 income tax entries for Lafleur Corp. for 20x8. (d) Identify the balances of all income tax accounts at December 31, 20x8, and show how they will be

reported on the comparative balance sheets at December 31, 20x8 and 20x7, and on the income statement for the year ended December 31, 20x8.

SOLUTION Problem 1 Deferred income taxes (net) @ December 31,20x2: NBV/UCC difference: ($1,706,240 - 1,144,660) x 35% $196,553 cr. Warranty liability: 60,000 x 35% 21,000 dr. Accrued Pension liability: 200,000 x 35% 70,000 dr. Loss carryforward: $280,000 x 35% 98,000 dr. $ 7,553 cr. Calculation of allowable CCA for the year: Class UCC - Beg Additions Disposals Rate CCA Claim UCC - End1 $629,450 4% $ 25,178 $ 604,2728 340,000 $40,000 $20,000 20% 70,000 1 290,00010 175,210 20,000 15,000 30% 53,313 2 126,897 $1,144,660 $60,000 $35,000 $148,491 $1,021,169 1 $340,000 x 20% + [(40,000 - 20,000) x 20% x 1/2] 2 $175,210 x 30% + [(20,000 - 15,000) x 30% x 1/2] Current portion of income taxes expense -

Net income before taxes $1,200,000 Permanent differences: Club dues 6,000 Non-taxable portion of entertainment expenses

10,000

Equity income (80,000) Temporary differences: Depreciation 180,000 CCA (148,491) Loss on sale of equipment (20,000 - 25,000) 5,000 Gain on sale of equipment (15,000 - 6,000) (9,000) Pension expense 75,000 Amount paid to pension trustee (100,000) Warranty expense 140,000 Warranty costs (125,000) Taxable income $1,153,509

Taxable income $1,153,509 Application of loss carryforward (280,000) 873,509 x 33% Current portion of income tax expense $ 288,258 Deferred income taxes (net) @ December 31,20x3: NBV/UCC difference: NBV: $1,706,240 - 180,000 Dep+ 60,000 Add -25,000 Disp - 6,000 Disp = (1,555,240 - 1,021,169) = 534,071 x 33% $176,243

cr.

Warranty liability: (60,000 + 140,000 - 125,000) x 33% 24,750 dr. Accrued Pension liability: (200,000 + 75,000 - 100,000) x 33% 57,750 dr. 93,743 cr. DIT @ December 31, 20x2 7,553 cr. Increase = Deferred Income Tax Portion of Income Tax Expense $86,190 Income Statement Presentation - Net income before taxes $1,200,000Provision for income taxes Current $288,258 Deferred 86,190 374,448Net income $ 825,552 The Statement of Financial Position presentation of the deferred tax assets and liabilities are as follows: Long-term assets Deferred tax assets ($24,750 + 57,750) $82,500 Long-term liabilities Deferred tax liabilities $176,243

Problem 2 Income before taxes $235,000Income tax - Current $45,000 - Deferred 60,750 105,750Net income $129,250 Taxable

Income Income before taxes $ 235,000Depreciation 200,000CCA (300,000)Loss on sale of depreciable asset 5,000Warranties 40,000 180,000Less loss carry over (80,000)Taxable Income 100,000 x 45%Current portion of income tax expense $45,000 Deferred income tax account, December 31, 20x1 On NBV/UCC, beginning of year: $157,500 / .45 $350,000 Excess of CCA over depreciation 100,000 Loss on sale of depreciable assets (5,000) 445,000 x 45% $200,250 cr On Warranty: 40,000 x 45% 18,000 dr $182,250 cr Deferred income tax expense = 182,250 – (157,500 – 36,000 On Loss CF) = $60,750

Problem 3 Income before taxes $700,000

Permanent Differences: Interest expense 3,500 Dividends from taxable Canadian corporations (35,000)

Timing Differences: Depreciation 157,500 CCA (245,000) Provision for warranties 70,000 Gain on sale of depreciable asset: $192,500 - 70,000 (122,500) $528,500

x 50%

$264,250 DIT Account Balance, December 31, 20x1:

On depreciable assets: NBV, end of year ($1,575,000 - 157,500 Dep - 70,000 Disposal) $1,347,500 UCC, end of year: (1,330,000 - 245,000 CCA - 192,500 Disposal) 892,500 455,000 x 50% 227,500 crOn Warranty: $70,000 x 50% 35,000 dr. $192,500 cr. The DIT expense is equal to: $192,500 cr. - 122,500 cr. Opening DIT Account* = $70,000 * (1,575,000 Opening NBV - 1,330,000 Opening UCC) x 50% Alternatively, the DIT expense can be calculated by taking the sum of the timing differences times the tax rate: 140,000 x 50% = $70,000. Note that this only works where there has been no tax rate change. The journal entries to record the provision for income taxes is as follows: Income tax expense - current $264,250 Income taxes payable $264,250 Income tax expense - deferred 70,000 DIT Account 70,000

Problem 4 20x0 20x1 20x2Accounting income $155,000 $(170,500) $232,500 Depreciation expense 77,500 77,500 77,500Capital cost allowance claimed (120,500) NIL (116,250)Taxable income 112,000 (93,000) 193,750

x 42% x 42% x 42%

Current portion of income tax expense $47,040 ($39,060)* $81,375 DIT Account Balance, beginning of year $186,000 $204,060 $171,510 Change during year: 20x2: $43,000 x 42% 18,060 20x3: ($77,500 x 42%) (32,550) 20x4: $38,750 x 42% 16,275 Balance, end of year $204,060 $171,510 $187,785 * carried back to 20x0 a) 20x0 Income tax expense - current $47,040 Income taxes payable $47,040 Income tax expense - deferred 18,060 DIT Account 18,060 20x1 Income taxes receivable 39,060 Income tax benefit - current 39,090 DIT Account 32,550 Income tax benefit - deferred 32,550 20x2 Income tax expense - current 81,375 Income taxes payable 81,375 Income tax expense - deferred 16,275 DIT Account 16,275

b) Cinnamon Ltd.

Partial Income Statement for the Year Ending December 31, 20x1

Loss before income taxes $(170,500)Income tax benefit Current $39,060 Deferred 32,550 71,610 Net loss $ (98,890) c) $187,785 per schedule above

Problem 5 20xl 20x2 20x3 Net income before tax $ 100,000 $ 100,000 $ 100,000Permanent differences: Dividend income -2,000 -2,000 -3,000Timing differences Warranty expense 3,000 3,000 3,000 Warranty costs -1,000 -4,000 -3,000 Depreciation 10,000 10,000 12,000 CCA -25 000 -15,000 -7,000 Pension expense 5,000 7,000 10,000 Pension funding -7,000 -8,000 -9,000Taxable income $ 83,000 $ 91,000 $103,000Tax rate 40% 44% 48%Income tax payable $33,200 $40,040 $49,440 Income tax expense:

Current $ 33,200 $40,040 $49,440 Deferred (see schedule) 6,000 3,680 -2,000Income tax expense $ 39,200 $43,720 $47,440 Temporary Differences and DIT - 20x1 Warranty - $2,000 x 40% $800 Dr. Fixed Assets: 110,000 NBV - 95,000 UCC = 15,000 x 40% 6,000 Cr. Pension Asset: $2,000 x 40% 800 Cr. Net DIT $6,000 Cr. Classification (IFRS) Long-term assets (Warranty) $800 Long-term liabilities (Fixed Assets & Pension) 6,800 Classification (ASPE) Current Assets (Warranty) $800 Long-term liabilities (Fixed Assets & Pension) 6,800 Temporary Differences and DIT - 20x2 Warranty: $1,000 x 44% 440 Dr. Fixed Assets: 100,000 NBV - 80,000 UCC = 20,000 x 44% 8,800 Cr. Pension Asset: $3,000 x 44% 1,320 Cr. Net DIT 9,680 Cr. Less DIT - beginning of year 6,000 Cr. Increase = DIT portion of Income Tax Expense 3,680

Classification (IFRS) Long-term assets (Warranty) 440 Long-term liability (Fixed Assets & Pension) 10,120 Classification (ASPE) Current Assets (Warranty) 440 Long-term liabilities (Fixed Assets & Pension) 10,120 Temporary Differences and DIT - 20x3 Warranty: $1,000 x 48% 480 Dr. Fixed Assets: 88,000 NBV - 73,000 UCC = 15,000 x 48% 7,200 Cr. Pension Asset: $2,000 x 48% 960 Cr. Net DIT 7,680 Cr. Less DIT - beginning of year 9,680 Cr. Decrease = DIT portion of Income Tax Expense (credit) 2,000 Classification (IFRS) Long-term assets (Warranty) 480 Long-term liability (Fixed Assets & Pension) 8,160 Classification (ASPE) Current Assets (Warranty) 480 Long-term liabilities (Fixed Assets & Pension) 8,160

Journal Entries: 20xl Income tax expense – current 33,200 Income taxes payable 33,200 Income tax expense – deferred 6,000 DIT Account 6,000 20x2 Income tax expense – current 40,040 Income taxes payable 40,040 Income tax expense – deferred 3,680 DIT Account 3,680 20x3 Income tax expense – current 49,440 Income taxes payable 49,440 DIT Account 2,000 Income tax expense – deferred 2,000

Problem 6 Income before taxes $1,000,000 Permanent differences - Nondeductible portion of entertainment expenses: $25,000 x 50% 12,500 Dividends received from a Canadian Corporation (70,000) Timing Differences Depreciation expense 300,000 CCA (400,000) Warranty expense 50,000 Warranty costs paid (30,000)

Taxable income $862,500

Tax rate 40%

Current portion of income tax expense $345,000 Warranty Amort.Temporary differences - beginning of year: $10,000 ÷ .4 | $250,000 ÷ .4 $25,000 $625,000Change in temporary differences 20,000 100,000Temporary differences - end of year: 45,000 725,000

x 45% x 45%

DIT Balances, end of year 20,250 326,250Less DIT Balances, beginning of year 10,000 250,000

Increase $10,250 $76,250 DIT expense = $76,250 - 10,250 = $66,000 Income tax expense Current $345,000 Deferred 66,000 $411,000 Statement of Financial Position Presentation (IFRS): DIT Long-Term Assets $20,250 DIT Long-Term Liabilities 326,250 Statement of Financial Position Presentation (ASPE): FIT Current Assets $20,250 FIT Long-Term Liabilities 326,250Problem 7 (a) On NBV/UCC: $1,256,000 - 998,000 = $258,000 x 30% $77,400 cr. On the restructuring charge: $199,500 x 30% 59,850 dr. Net DIT Account $17,550 cr.

Statement of Financial Position Presentation (IFRS) -

Long-Term Assets DIT $59,850 Long-Term liabilities DIT $77,400 (b) 20x5 20x6

Income before taxes and discontinued items $850,000 $525,000

Permanent differences Life insurance premiums 9,000 9,000 Dividends (2,250) (2,750)

Timing differences Depreciation 175,000 180,000 CCA:

$998,000 x 20% + (250,000 - 60,000) x 20% x 1/2 (218,600) $969,400 x 20% + (180,000 – 50,000) x 20% x 1/2 (206,880) Gain/Loss on sale of asset (10,000) 30,000

Restructuring charges (131,500) (68,000)

Profit on land development (52,000) Taxable profit on land development 5,200 15,600

Taxable income 624,850 481,970

x 30% x 32%

$187,455 $154,230 Add taxes on income for discontinued operations $18,800 x 30% 5,640

Taxes payable $193,095 $154,230

(c) NBV UCC

Balance, beginning of 20x5 $1,256,000 $998,000 Additions 250,000 250,000 Disposals (50,000) (60,000) Depreciation/CCA (175,000) (218,600)

Balance, end of 20x5 1,281,000 969,400 Additions 180,000 180,000 Disposals (80,000) (50,000) Depreciation/CCA (180,000) (206,880)

Balance, end of 20x6 $1,201,000 $892,520 DIT Account, end of 20x5: On NBV/UCC: $1,281,000 - 969,400 = $311,600 x 30% $93,480 cr. On restructuring charges: $68,000 x 30% 20,400 dr. On land development gain: ($52,000 - 5,200) x 30% 14,040 cr. $87,120 cr. DIT expense, 20x5: $87,120 - 17,550 = $69,570 DIT Account, end of 20x6: On NBV/UCC: $1,201,000 – 892,520 = $308,480 x 32% $ 98,714 cr. On land development gain: ($52,000 - 5,200 - 15,600) x 32% 9,984 cr. $108,698 cr. DIT expense, 20x6: $108,698 - 87,120 = $21,578 20x5 Income tax expense - current $187,455 Discontinued Operations Gain 5,640 Income tax payable $193,095 Income tax expense - deferred 69,570 DIT Account 69,570 20x6 Income tax expense – current 154,230 Income tax payable 154,230 Income tax expense – deferred 21,578 DIT Account 21,578

(d) IFRS - 20x5 Long-Term Assets DIT $20,400 Long-Term Liabilities DIT ($93,480 + 14,040) 107,520 20x6 Long-Term Liabilities DIT (98,714 + 9,984) 108,698 ASPE - 20x5 Current Assets FIT [20,400 - $14,040 / 3] $15,720 Long-Term Liabilities FIT [$93,480 + (14,040 x 2/3)] 102,840 20x6 Current Liabilities FIT ($9,984 / 2) 4,992 Long-Term Liabilities FIT [98,714 + (9,984/2)] 103,706

Problem 8 Calculation of Current Income Taxes Payable: Year 1 Year 2Income before taxes $1,300,000 $1,550,000

Permanent differences Entertainment expenses 42,000 Dividends received from taxable Canadian corp. (75,000)

Timing Differences

Depreciation 140,000 140,000 CCA (67,000) (370,000) Loss on sale of asset (85,000 - 60,000) 25,000

Warranty expense 357,000 387,000 Warranty costs incurred (264,000) (342,000)

Amortization of franchise fee revenues (9,000) (9,000) Franchise fee revenues 90,000

Pension expense 60,000 75,000 Payments made to pension plan trustee (20,000) (200,000) 1,629,000 1,181,000 x 35% x 37%Current income taxes payable $570,150 $436,970 DIT Account, end of Year 1 NBV/UCC: $893,000 – 820,000 = $73,000 x 35% 25,550 dr.Warranty liability: $93,000 x 35% 32,550 dr.Franchise: $81,000 x 35% 28,350 dr.Pension liability: $40,000 x 35% 14,000 dr. $100,450 dr. Income tax expense, Year 1 Net income before taxes $1,300,000Provision for income taxes Current $570,150 Deferred (100,450) 469,700Net Income $830,300

Classification of DIT Account on Statement of Financial Position, Year 1 Long-Term assets DIT $100,450 DIT Account, end of Year 2: NBV/UCC difference: 132,000 x 37% 48,840 Cr. Warranty liability: 138,000 x 37% 51,060 Dr. Franchise fee: (90,000 - 9,000 - 9,000) = 72,000 x 37% 26,640 Dr. Pension Account: $85,000 dr.* x 37% 31,450 Cr. 2,590 Cr. * Total pension expense in years less total contributions made in Years 1 and 2:

$60,000 + 75,000 – 20,000 – 200,000 = $85,000 dr. Income tax expense, Year 2 Net income before taxes $1,550,000Provision for income taxes Current $436,970 Deferred (100,450 + 2,590) 103,040 540,010Net Income $1,009,990 Classification of DIT Balances on Statement of Financial Position, Year 2 Long-Term Assets DIT ($51,060 + 26,640) $77,700 Long-Term Liabilities DIT ($48,840 + 31,450) $80,290

Problem 9 (a) On rent recoverable: $440,000 x 40% $176,000 cr. On unearned rent: $360,000 x 40% 144,000 dr. $32,000 cr. (b) Income before taxes $1,140,000

Permanent Differences - Dividend income (15,000) Nondeductible fines and interest expense 38,000

Timing Differences - Rent recoverable (440,000) Unearned rent revenues 360,000 Taxable income $1,083,000

x 42%

Current portion $454,860 (c) Income tax expense - current $454,860 Income taxes payable $454,860 Income tax expense – deferred 32,000 DIT Account 32,000 (d) Net income before taxes $1,140,000 Provision for income taxes Current $454,860 Deferred 32,000 486,860 Net income $ 653,140 (e) Long-Term Assets DIT $144,000 Long-term liabilities DIT 176,000

Problem 10 (a) On rent recoverable: $350,000 x 40% $140,000 cr. On unearned rent: $410,000 x 40% 164,000 dr. $24,000 dr. (b) Income before taxes $1,280,000

Permanent Differences - Dividend income (20,000) Nondeductible fines and interest expense 6,000

Timing Differences - Rent recoverable 90,000 Unearned rent revenues 50,000 Taxable income $1,406,000

x 40%

Current portion $562,400 (c) Income tax expense - current $562,400 Income taxes payable $562,400 DIT Account 56,000 Income tax expense – deferred 56,000 (d) Net income before taxes $1,280,000 Provision for income taxes Current $562,400 Deferred (56,000) 506,400 Net income $ 773,600 (e) Long-term Assets DIT $164,000 Long-term liabilities DIT 140,000

Problem 11 (a) 20x6 Current portion = $120,000 x 34% = $40,800 Income tax expense – current $40,800 Income taxes payable $40,800 20x7 Current portion = $90,000 x 34% = $30,600 Income tax expense – current 30,600 Income taxes payable 30,600 20x8 Accounting Loss ($280,000) Carry backs: To 20x6 120,000 To 20x7 90,000 Carried forward $ 70,000 Income taxes receivable ($40,800 + 30,600) 71,400 Income tax benefit – current 71,400 DIT Account ($70,000 x 38%) 26,600 Income tax benefit – deferred 26,600 20x9 Accounting income $220,000 Less carryover 70,000 Taxable income $150,000

x 38%

$57,000 Income tax expense – current $57,000 Income taxes payable $57,000 Income tax expense – deferred 26,600 DIT Account 26,600

(b) 20x8 Loss before taxes ($280,000) Income tax benefit Current $71,400 Deferred 26,600 98,000 Net loss ($182,000) 20x9 Net income before taxes $220,000 Provision for income taxes Current $57,000 Deferred 26,600 83,600 Net income $136,400

Problem 12 (a) DIT Account, Dec 31, 20x7 • On NBV/UCC difference: ($17,500 x 30%) + (12,500 x 29%) + (2,000 x 28%) $ 9,435 cr. • On warranty liability: $18,500 x 30% 5,550 dr. • On pension liability: ($11,000 x 30%) + (11,000 x 29%) + (12,600 x 28%) 10,018 dr. $ 6,133 dr. Balance sheet classification: Long-Term Assets DIT Account ($5,550 + 10,018) $15,568 Long-term Liabilities DIT Account $9,435 (b) • On NBV/UCC difference: (12,500 x 29%) + (2,000 x 28%) $4,185 cr. • On warranty liability: $22,300 x 29% 6,467 dr. • On pension liability: (11,000 x 29%) + (12,600 x 28%) 6,718 dr. $9,000 dr. DIT Expense = $9,000 – 6,133 = $2,687 cr. (c) Net income before taxes $109,400 Permanent differences Dividends received from taxable Canadian Corporations (4,300) Club dues 20,000 Timing differences Excess of depreciation over CCA 17,500 Warranty expense 28,300 Warranty costs incurred (24,500) Pension expense 59,000 Payments to pension trustee (70,000) Taxable income 135,400

x 30%

Current portion $40,620 Income tax expense – current 40,620 Income taxes payable 40,620 DIT Account 2,687 Income tax expense – deferred 2,687(d) Net income before taxes $109,400 Provision for income taxes Current $40,620 Deferred (2,687) 37,933 Net income $71,467

Balance Sheet Classification Long-term Assets DIT Account ($6,467 + 6,718) $13,185 Long-term Liabilities DIT Account $4,185 Current liabilities Income taxes payable ($40,620 – 32,000) $8,620

BUSI 2002 – Intermediate Accounting II Chapter 20 – Leases Additional Problems with Solutions Problem 1 Sampson Ltd. leases equipment to Bowie Ltd. on January 1, 20x0, for five years. The following information pertains to the lease agreement: • Sampson Ltd. paid $43,438 to acquire the equipment on January 1, 20x0. • Rental payments are $10,000 annually for five years; the first payment is due in January 1, 20x0, subsequent

payments are due on December 31 of each year (i.e. the second payment is due on December 31, 20x0). • A purchase option to buy the asset for $3,000 exists at the end of the fifth year. • The fair value of the leased equipment is $43,438. • Estimated economic life of the equipment is eight years. • Sampson Ltd. pays executory costs related to the leased property. A fair estimate of such costs included in the annual rental payments is $400 annually. • Bowie Ltd.'s incremental borrowing rate is 6%. The interest rate implicit in the lease, known to the lessee, is

8%. • the residual value of the equipment at the end of five years is $8,000; residual value at the end of eight years is $1,000. • Bowie Ltd. depreciates similar equipment on the straight-line basis. • Bowie Ltd. has a calendar year-end. Required – For each part, determine whether the lease is a finance or operating lease, calculate the lease payment, prepare an amortization schedule for the lease term, prepare the journal entries for the years 20x0, 20x1 and the final journal entry at December 31, 20x4.

a. Using the facts outlined above. b. Assume the same facts as in (a) with the following exception: there is no option to purchase the asset at

the end of the 5th year. The equipment reverts back to the lessor at the end of the 5th year. The lessee guarantees the residual value of the asset ($8,000). Annual lease payments are $9,211 (including the $400 executory costs).

c. Assume the same facts as in (c), with the following exception: there is no option to purchase the asset at the end of the 5th year. The equipment reverts back to the lessor at the end of the 5th year. The lessee does not guarantee the residual value of the asset ($8,000). Annual lease payments are $9,211 (including the $400 executory costs).

Problem 2 JKL Company manufactures and distributes heavy equipment. One of its popular lathes costs $67,500 to make and sells for $100,000. On January 1, 20x8, MNO agrees to lease a lathe for 4 years from JKL. The lathe is expected to have a useful life of 6 years and no residual value at that time. However, it is expected to have a residual value of $9,000 at the end of the lease at which time MNO has the option to purchase it for $3,000. The first payment is due on January 1, 20x8. The rate implicit in the lease, known to MNO, is 12% while MNO's incremental borrowing rate is 14%. Required a. Compute the lease payment. b. Prepare all 20x8 journal entries for MNO. Problem 3 The McGrath Corporation entered into a 5 year lease agreement for equipment on December 31, 20x3. Data relative to this transaction is as follows:

Fair value of equipment $250,000Economic life of equipment 10 yearsResidual value at end of economic life 20,000

For each of the independent situations below, prepare all journal entries relative to this lease for the year 20x4 and 20x5.

(a) The rate implicit in the lease is 8%. The lease agreement includes an option to purchase the equipment at the end of the lease term for $10,000. The fair value of the equipment at the end of the lease term is estimated to be $60,000.

(b) The rate implicit in the lease is 8%. The lease agreement requires McGrath to return the equipment at the end of the lease term and to guarantee the residual value of $60,000.

(c) The rate implicit in the lease is 8%. The lease agreement requires McGrath to return the equipment at the end of the lease term. The residual value of $60,000 was considered in calculating the lease payments by the lessor but is unguaranteed.

(d) The rate implicit in the lease is not known, nor is the fair value of the equipment. The lease term is for 8 years. McGrath’s incremental borrowing rate is 7% and the annual lease payment is $42,000.

Problem 4 On January 3, 20x5, Thermotech Inc. leased a specialized piece of diagnostic equipment to Eastview Medical Clinic. Details are as follows: Cost to manufacture to Thermotech $ 80,000Normal sales price $100,000Lease term 8 yearsEconomic Life 10 yearsResidual value at the end of the lease term $20,000Residual value at end of useful life $ 500Lease payment (1st payment payable January 3, 20x5) $16,881Purchase option (exercisable at end of year 8) $ 2,000Incremental borrowing rate of Eastview 12%Rate implicit in the lease 10% Assume that Thermotech has reasonable assurance that Eastview will make the remaining lease payments. All costs of operating the leased equipment are borne by Eastview. Assume that subsequent payments are due on December 31st of every year. Required. Prepare the journal entries and disclosure for Thermotech Inc. and Eastview Medical Clinic for 20x5 and 20x6. Assume that both companies have a December 31 year-end.

Problem 5 At the beginning of 20x2, Agudelo entered into a 20-year, non-cancellable, long-term lease agreement for a truck terminal that had been constructed on Agudelo’s land. The terminal has a useful life of 40 years, and Agudelo can acquire title to the facility at the end of the lease term by paying the lessor $1. The annual lease payments over the lease term, payable at the beginning of the year, are as follows: First 10 years $1,000,000 per year Second 10 years 300,000 per year Agudelo also must make annual payments to the lessor of $75,000 for property taxes and $125,000 for insurance. The implicit rate in the lease (known to Agudelo) was 6%. On January 1, 20x2, Agudelo made the first payment of $1.2 million to the lessor. Required – a. Discuss how Agudelo should classify the truck terminal lease. b. Prepare all necessary entries for Agudelo for the year 20x2. Problem 6 On December 31, 20x3, Cooray Inc. sold a building with a net book value of $1,800,000 to Gardner Industries for $1,757,346. Cooray immediately entered into a leasing agreement whereby Cooray would lease the building back for an annual payment of $260,000. The term of the lease is 10 years, the expected remaining useful life of the building. The first annual lease payment is to be made immediately, and future payments will be made on December 31 of each succeeding year. Gardner’s implicit interest rate is 10%. The building has a residual value of $0 and the Cooray Company amortizes its buildings using the straight-line method. Required - 1. Prepare the journal entries that should be made by Cooray on December 31, 20x3, relating to this sale

and leaseback transaction. 2. Prepare the journal entries that should be made by Cooray for the year ended December 31, 20x4,

relating to this sale and leaseback transaction.

SOLUTIONS Problem 1 a. Classification of lease contract by Bowie Ltd.: Criteria Assessment 1. The lease transfers ownership of the asset to

the lessee by the end of the lease term.

No

2. The lessee has the option to purchase the asset at a price that is expected to be substantially lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised.

Yes. Bowie Ltd. can acquire the equipment for $3,000 at the end of the lease term when its estimated fair market value is $8,000.

3. The lease term is for the major part of the economic life of the asset even if title is not transferred.

No. The lease term of 5 years is about 63% of the equipment' s economic life of 8 years.

4. At the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.

Yes - the present value of the minimum lease payments is equal to 100% of the fair value of the asset. See schedule below.

5. The leased assets are of such a specialized

nature that only the lessee can use them without major modification.

Unknown.

The present value of annual lease payments and bargain purchase option – set your financial calculator to assume that the cash flows occur at the beginning of the year (BGN mode). Once you have completed the calculation, set it back to normal mode.

[BGN] N I/Y PV PMT FV Enter 5 8 9600 3000 Compute X =

$43,438

Conclusion: due to the existence of the bargain purchase option, this is a finance lease.

The interest expense and liability reduction schedule is as follows: Date Payment Interest

Principal Reduction Balance

Jan 2, 20x0 $43,438Jan 2, 20x0 $9,600 - $9,600 33,838Dec 31, 20x0 9,600 2,707 6,893 26,945Dec 31, 20x1 9,600 2,156 7,444 19,501Dec 31, 20x2 9,600 1,560 8,040 11,461Dec 31, 20x3 9,600 917 8,683 2,778Dec 31, 20x4 3,000 222 2,778 0 Bowie Ltd.'s journal entries for 20x0 and 20x1 are as follows: Jan 1, 20x0 Equipment under finance lease $43,438 Obligation under finance lease $43,438 Executory costs 400 Obligation under finance lease 9,600 Cash 10,000 Dec 31, 20x0 Prepaid executory costs 400 Interest expense 2,707 Obligation under finance lease 6,893 Cash 10,000 Depreciation expense 5,305 Accumulated depreciation 5,305 ($43,438 - 1,000) / 8 Jan 1, 20x1 Executory Costs 400 Prepaid Executory Costs 400 Dec 31, 20x1 Prepaid executory costs 400 Interest expense 2,156 Obligation under finance lease 7,444 Cash 10,000 Depreciation expense 5,305 Accumulated depreciation 5,305 ($43,438 - 1,000) / 8

The December 31, 20x4, journal entries follow: Interest expense 222Obligation under finance lease 2,778 Cash 3,000 Depreciation expense 5,305 Accumulated depreciation 5,305 Equipment 43,438 Equipment under finance lease 43,438 b. Classification of lease contract by Bowie Ltd.: Criteria Assessment 1. The lease transfers ownership of the asset to

the lessee by the end of the lease term.

No

2. The lessee has the option to purchase the asset at a price that is expected to be substantially lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised.

No.

3. The lease term is for the major part of the economic life of the asset even if title is not transferred.

No. The lease term of 5 years is about 63% of the equipment' s economic life of 8 years.

4. At the inception of the lease the present value

of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.

Yes - the present value of the minimum lease payments is equal to 100% of the fair value of the asset. See schedule below.

5. The leased assets are of such a specialized

nature that only the lessee can use them without major modification.

Unknown.

The present value of annual lease payments and guaranteed residual value – set your financial calculator to assume that the cash flows occur at the beginning of the year (BGN mode). Once you have completed the calculation, set it back to normal mode.

[BGN] N I/Y PV PMT FV Enter 5 8 8,811 8,000 Compute X =

$43,438

Conclusion: due to the existence of the guaranteed residual value, this is a finance lease. The interest expense and liability reduction schedule is as follows: Date

Payment

Interest

Principal Reduction Balance

Jan 2, 20x0 $43,438Jan 2, 20x0 $8,811 - $8,811 34,627Dec 31, 20x0 8,811 2,770 6,041 28,586Dec 31, 20x1 8,811 2,287 6,524 22,062Dec 31, 20x2 8,811 1,765 7,046 15,016Dec 31, 20x3 8,811 1,201 7,610 7,406Dec 31, 20x4 - 594 8,000 Bowie Ltd.'s journal entries for 20x0 and 20x1 are as follows: Jan 1, 20x0 Equipment under finance lease $43,438 Obligation under finance lease $43,438 Executory costs 400 Obligation under finance lease 8,811 Cash 9,211 Dec 31, 20x0 Prepaid executory costs 400 Interest expense 2,770 Obligation under finance lease 6,041 Cash 9,211 Depreciation expense 7,088 Accumulated depreciation 7,088 ($43,438 - 8,000) / 5 Jan 1, 20x1 Executory Costs 400 Prepaid Executory Costs 400 Dec 31, 20x1 Prepaid executory costs 400 Interest expense 2,287 Obligation under finance lease 6,524 Cash 9,211 Depreciation expense 7,088 Accumulated depreciation 7,088

The December 31, 20x4, journal entries follow: Interest expense 594 Obligation under finance lease 594 Depreciation expense 7,088 Accumulated depreciation 7,088 Accumulated depreciation 35,438Obligation under finance lease 8,000 Equipment under finance lease 43,438 If the appraisal value of the equipment works out to less than $8,000, then the lessee will have to make up the difference. This difference will simply be expensed at the time it is known. The differences between part (a) (Bargain Purchase Option) and part (b) (guaranteed residual value) can be summarized as follows: • in part (b), the asset reverts back to the lessor at the end of the lease term, • the guaranteed residual value is included as part of the minimum lease payments, • the asset is depreciated over 5 years down to its residual value of $8,000 • at the end of the lease term, just before the asset reverts to the lessor, the lessee has an net asset balance

of $8,000 and an obligation under capital lease of $8,000. These net out against the other when the asset is removed from the books.

c. Classification of lease contract by Bowie Ltd.: Criteria Assessment 1. The lease transfers ownership of the asset to

the lessee by the end of the lease term.

No

2. The lessee has the option to purchase the asset at a price that is expected to be substantially lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised.

No.

3. The lease term is for the major part of the economic life of the asset even if title is not transferred.

No. The lease term of 5 years is about 63% of the equipment' s economic life of 8 years.

4. At the inception of the lease the present value

of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.

Yes - the present value of the minimum lease payments is equal to 87% of the fair value of the asset. See schedule below.

5. The leased assets are of such a specialized

nature that only the lessee can use them without major modification.

Unknown.

The present value of annual lease payments and bargain purchase option – set your financial calculator to assume that the cash flows occur at the beginning of the year (BGN mode). Once you have completed the calculation, set it back to normal mode.

[BGN] N I/Y PV PMT FV Enter 5 8 8,811 Compute X =

$37,994

Conclusion: the most likely conclusion would be that this lease is an operating lease, given that the lease term is 63% of the economic life and that the present value of the minimum lease payments is equal to 87% of the fair value of the asset. The classification of this lease would be based on managerial judgment and may consider other factors. Two solutions will be presented: the first assuming that the lease classification is a finance lease and the second on the assumption that it is an operating lease.

Finance Lease Assumption - Per IAS 17.20, the lease would be recorded as an asset and liability of $37,994. The interest expense and liability reduction schedule is as follows: Date

Payment

Interest

Principal Reduction Balance

Jan 2, 20x0 $37,994 Jan 2, 20x0 $8,811 - $8,811 29,183Dec 31, 20x0 8,811 2,335 6,476 22,707Dec 31, 20x1 8,811 1,817 6,994 15,712Dec 31, 20x2 8,811 1,257 7,554 8,158Dec 31, 20x3 8,811 653 8,158 0 Bowie Ltd.'s journal entries for 20x0 and 20x1 are as follows: Jan 1, 20x0 Equipment under finance lease $37,994 Obligation under finance lease $37,994 Executory costs 400 Obligation under finance lease 8,811 Cash 9,211 Dec 31, 20x0 Prepaid executory costs 400 Interest expense 2,335 Obligation under finance lease 6,476 Cash 9,211 Depreciation expense 7,599 Accumulated depreciation 7,599 $37,994 / 5 Jan 1, 20x1 Executory Costs 400 Prepaid Executory Costs 400 Dec 31, 20x1 Prepaid executory costs 400 Interest expense 1,817 Obligation under finance lease 6,994 Cash 9,211 Depreciation expense 7,599 Accumulated depreciation 7,599 The differences between part (b) (guaranteed residual value) and (c) (unguaranteed residual value) can be summarized as follows: • the unguaranteed residual value is included as part of the minimum lease payments, • the lessor will likely include the residual value as part of the calculation of the lease payment, • the asset is depreciated over 5 years down to zero.

Operating Lease Assumption Jan 1, 20x0 Prepaid lease payment 9,211 Cash 9,211 Dec 31, 20x0 Lease expense 9,211 Prepaid lease payment 9,211 Jan 1, 20x1 Prepaid lease payment 9,211 Cash 9,211 Dec 31, 20x1 Lease expense 9,211 Prepaid lease payment 9,211

Problem 2 a. Calculation of lease payments -

[BGN] N I/Y PV PMT FV Enter 4 12 -100000 3000 Compute X =

$28,835

b. Lease is a finance lease due to the presence of bargain purchase option. Jan 1, x8 Asset under finance lease $100,000 Lease liability (100,000 - 28,836) $71,165 Cash 28,835 Dec 31, x8 Interest expense (71,165 x 12%) 8,540 Interest payable 8,540 Dec 31, x8 Depreciation expense 16,667 Accumulated Depreciation 16,667 (100,000 ÷ 6)

Problem 3 (a) This is a finance lease due to the presence of the bargain purchase option. It is

assumed that the lessee will exercise the bargain purchase option and keep the asset for its economic life.

Lease Payment: [BGN] N = 5, I = 8, PV = 250,000, FV = -10,000 Solve for PMT = $56,398 Dec 31, 20x3 Equipment under Finance Lease $250,000 Cash $56,398 Lease Obligation 193,602 Dec 31, 20x4 Interest expense ($193,602 x 8%) 15,488 Lease obligation 40,910 Cash 56,398 Depreciation expense 23,000 Accumulated depreciation 23,000 ($250,000 – 20,000) / 10 Dec 31, 20x5 Interest expense

($193,602 – 40,910) x 8% 12,215 Lease obligation 44,183 Cash 56,398 Depreciation expense 23,000 Accumulated depreciation 23,000

(b) This is a finance lease since the existence of the guaranteed residual value makes the present value of the minimum lease payments equal the fair value of the equipment.

Lease Payment: [BGN] N = 5, I = 8, PV = 250,000, FV = -60,000 Solve for PMT = $48,506 Dec 31, 20x3 Equipment under Finance Lease $250,000 Cash $48,506 Lease Obligation 201,494 Dec 31, 20x4 Interest expense ($201,494 x 8%) 16,120 Lease obligation 32,386 Cash 48,506 Depreciation expense 38,000 Accumulated depreciation 38,000 ($250,000 – 60,000) / 5 Dec 31, 20x5 Interest expense

($201,494 – 32,386) x 8% 13,529 Lease obligation 34,977 Cash 48,506 Depreciation expense 38,000 Accumulated depreciation 38,000

(c) Lease Payment: [BGN] N = 5, I = 8, PV = 250,000, FV = -60,000 Solve for PMT = $48,506 Present value of lease payments: N = 5, I = 8, PMT = 48,506 Solve for PV = 209,164 PV as a % of the fair value of equipment = $209,164 / 250,000 = 84% Lease term as a % of economic life = 5/10 = 50% This lease should be classified as an operating lease since it does not transfer the

rights, rewards and risks of ownership to McGrath. Dec 31, 20x3 Prepaid rent $48,506 Cash $48,506 Dec 31, 20x4 Rent expense 48,506 Cash 48,506 Dec 31, 20x5 Rent expense 48,506 Cash 48,506

(d) PV of minimum lease payments: [BGN] N = 8, I = 7, PMT = 42,000 Solve for PV = $268,350 This one is a little trickier. The lease term is 80% of the economic life of the asset

which is an indicator of a finance lease, however we cannot compare the present value of the minimum lease payments to the fair value of the equipment since the latter is unknown. It would be up to managerial judgment to determine whether the present value of the minimum lease payments covers a substantial portion of the fair value of the equipment. The fact that the lease term covers 80% of the economic life of the asset is significant and therefore, we will classify this lease as a finance lease.

Dec 31, 20x3 Equipment under Finance Lease $268,350 Cash $42,000 Lease Obligation 226,350 Dec 31, 20x4 Interest expense ($226,350 x 7%) 15,844 Lease obligation 26,156 Cash 42,000 Depreciation expense 33,544 Accumulated depreciation 33,544 $268,350 / 8 Dec 31, 20x5 Interest expense

($226,350 – 26,156) x 7% 14,014 Lease obligation 27,986 Cash 42,000 Depreciation expense 33,544 Accumulated depreciation 33,544

Problem 4 Lease Classification Criteria

Assessment

1. The lease transfers ownership of the asset to the lessee by the end of the lease term.

No

2. The lessee has the option to purchase the asset at a price that is expected to be substantially lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised.

Yes. Purchase option is $2,000 when equipment is estimated to have a residual value of $20,000

3. The lease term is for the major part of the economic life of the asset even if title is not transferred.

Yes. The lease term is about 80% of the equipment' s economic life.

4. At the inception of the lease the present value

of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.

Yes. The present value of the minimum lease payments is equal to 100% of the fair value of the property. See schedule below.

5. The leased assets are of such a specialized

nature that only the lessee can use them without major modification.

Unknown.

[BGN] N I/Y PV PMT FV Enter 8 10 16881 2000 Compute X =

$99,998

Therefore, lease is a finance lease from the lessee's point of view

Journal Entries - Lessee Jan 1, 20x5 Asset Under Finance Lease $100,000 Cash $16,881 Finance Lease Obligation 83,119 Dec 31, 20x5 Interest Expense (83,119 x 10%) 8,312 Finance Lease Obligation 8,569 Cash 16,881 Depreciation expense 9,950 Accumulated depreciation 9,950 (100,000 - 500 ) ÷ 10 years Dec 31, 20x6 Interest Expense (83,119 - 8,569) x 10% 7,455 Finance Lease Obligation 9,426 Cash 16,881 Depreciation entry same as for 20x5 Journal Entries - Lessor Jan 1, 20x5 Lease receivable $83,119 Cash 16,881 Sales $100,000 Cost of goods sold 80,000 Finished Goods Inventory 80,000 Dec 31, 20x5 Cash 16,881 Lease Receivable 8,569 Interest Revenue 8,312 Dec 31, 20x6 Cash 16,881 Lease Receivable 9,426 Interest Revenue 7,455

Problem 5 a. Criteria

Assessment

1. The lease transfers ownership of the asset to the lessee by the end of the lease term.

No

2. The lessee has the option to purchase the asset at a price that is expected to be substantially lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised.

Yes.

3. The lease term is for the major part of the economic life of the asset even if title is not transferred.

No. The lease term is only 50% of the equipment' s economic life.

4. At the inception of the lease the present value

of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.

Unknown since we do not know the FMV of the property

5. The leased assets are of such a specialized

nature that only the lessee can use them without major modification.

Unknown.

Lease is a finance lease due to the bargain purchase option.

b. PV of the first 10 years of payments:

[BGN] N I/Y PV PMT FV Enter 10 6 1000000 Compute X =

$7,801,692

PV of the last 10 years of payments (remember to take your calculator off the BEGIN mode:

N I/Y PV PMT FV Enter 10 6 300000 Compute X =

$2,208,026

This is a present value at t=9, so we need to bring it back to t=0:

N I/Y PV PMT FV Enter 9 6 2208026 Compute X =

$1,306,927

Total PV of minimum lease payments: $7,801,692 + 1,306,927 = $9,108,619 Jan 1, x2 Terminal under finance lease $9,108,619 Lease liability $9,108,619 Jan 1, x2 Lease liability 1,000,000 Property taxes (or prepaid) 75,000 Insurance (or prepaid) 125,000 Cash $1,200,000 Dec 31, x2 Interest expense 486,517 Interest payable 486,517 (9,108,619 – 1,000,000) x 6% = 486,518 Dec 31, x2 Depreciation expense 227,715 Accumulated depreciation 227,715 $9,108,619 / 40 years

Problem 6 1. Dec 31, 20x3 Building under Finance Lease $1,757,346 Deferred loss on sale-leaseback 42,654 Building $1,800,000 Cash ($1,757,346 – 260,000) 1,497,346 Lease obligation 1,497,346 2. Dec 31, 20x4 Interest expense ($1,497,346 x 10%) 149,735 Lease obligation 110,265 Cash 260,000 Depreciation expense 175,735 Accumulated depreciation 175,735 $1,757,346 / 10 Depreciation expense 4,265 Deferred loss on sale-leaseback 4,265 $42,654 / 10

BUSI 2002 – Intermediate Accounting II Chapter 21 – Accounting Changes and Error Analysis Additional Problems with Solutions Problem 1 In December 20x5, the Morrow Company, a private company subject to ASPE, has decided to change its depreciation policy on its building from the diminishing balance to the straight-line method. The motivation for the change is that the straight-line method results in the financial statements being more reliable and relevant. The building was purchased on January 1, 20x2, for $450,000 and was being depreciated at 4% per annum, diminishing balance. Calculate the effect of the change in principle on the 20x5 financial statements and the 20x4 comparative numbers. Assume that the useful life of the building is 40 years and that the residual value is $50,000. Problem 2 The Barlow Company acquired a building on January 1, 20x0, for $500,000. The building is being depreciated on the straight-line basis over 40 years with no residual value. We are now in December 20x5 and have determined that the building had in fact an estimated useful life of only 30 years with an estimated residual value of $80,000. The company year-end is December 31. What is depreciation expense on the building for the year ended December 31, 20x5? Problem 3 On January 1, 20x2 a machine is purchased for $500,000. The useful life of the machine is 10 years and the residual value is $100,000. The company’s accounting policy is to use the diminishing method of depreciation at the rate of 20%. During, 20x5 the company (subject to ASPE) decides to switch to the straight line method of depreciation. Assuming a tax rate of 40%, a fiscal year that coincides with the calendar year and that this change qualifies as a change in accounting policy, what will the journal entry to account for this change be? Problem 4 On October 31, 20x4 a two year insurance policy was purchased in the amount of $240,000 and was expensed to insurance expense. No adjustment was made at December 31, 20x4, the company’s year end. This error was discovered during 20x5 after the 20x4 financial statements were issued. The company’s tax rate is 40%. Prepare the journal entry to correct this error in 20x5. Problem 5

On January 2, 20x3, land costing $250,000 is purchased and is debited to the equipment account by error. This error is discovered in 20x5. The company amortizes equipment on the diminishing balance at the rate of 10%. What are the journal entries to correct this error in 20x5? Assume that the company’s fiscal year is the calendar year and that the tax rate is 40%. The equipment belongs to class 8 (20%).

Problem 6

Travis Corporation has just completed its financial statements for the reporting year ended December 31, 20x5. The pretax income amount is $160,000. The accounts have not been closed for December 31, 20x5. Further consideration and review of the records revealed the following items related to the 20x5 statements: a. On January 1, 20x1, a machine was acquired that cost $10,000. The estimated useful life was 10 years,

and the residual value was $2,000. At the time of acquisition, the full cost of the machine was incorrectly debited to the land account. Assume straight-line depreciation. The machine belongs to Class 8 - 20% for CCA purposes.

b. On January 1, 20x3, a long-term investment of $18,000 was made by purchasing a $20,000, 8% bond of

XT Corporation. The investment account was debited for $18,000. Each year, starting on December 31, 20x3, the company has recognized and reported investment revenue on these bonds of $1,600. The bonds mature in 10 years from the date of purchase.

c. The 20x4 ending inventory was overstated by $7,000. d. A $11,000 purchase of merchandise occurred on December 18, 20x4. Because the merchandise was on

hand on December 31, 20x4, it was included in the 20x4 ending inventory. The purchase was recorded on January 18, 20x5, when the invoice was paid.

Required 1. Prepare any correcting and adjusting entries that should be made on December 31, 20x5. Assume a tax

rate of 40%. 2. Compute the correct pretax income for 20x5. Set up an appropriate schedule that reflects each change

and the correct pretax income for 20x5.

Problem 7 The Lisgar Company is in the process of preparing its adjusting entries for the year 20x9 and has come across the following items: i. It was discovered that a Truck costing $120,000 was expensed during the year 20x6. The truck was

acquired on January 3, 20x6. The useful life of the truck is 10 years and a residual value of $20,000. The company uses the diminishing balance method to depreciate its capital assets at a rate of 20%. The asset is a Class 10 asset (30%). The truck was never added to the UCC class in 20x6.

ii. The company’s building was acquired at a cost of $1,500,000 on January 1, 20x0. The residual value and useful life of the building was estimated to be $200,000 and 40 years respectively, at the time. You now estimate that the residual value of the building will only be $100,000 and the total estimated useful life to be 35 years. Depreciation is on the straight line basis and has already been recorded for the year 20x9.

Required - Prepare the journal entries to record the adjustments required by the above. Assume a tax rate of 35%. Problem 8 The Holbrook Company which uses the straight-line method of depreciation, purchased three machines on the first day of business in January 20x0. Details of the purchase are as follows: MACHINE X MACHINE Y MACHINE Z Cost $15,000 $15,000 $15,000 Estimated life 5 years 6 years 8 years Estimated scrap None $ 2,400 $ 600 During the first week of business in January 20x5, Machine X was sold for $2,000. This prompted management to re-examine not only the useful life expectancy but also the scrap expectancy of machines Y and Z. They decided that Machine Y had a remaining life of three years as of January 1, 20x5, and that the scrap evaluation of $2,400 was about right. Machine Z's estimated scrap value is $0 and has a remaining useful life of 4 years. Required - Prepare journal entries to reflect all of the events and information related to the three machines during 20x5, including depreciation expense.

Problem 9 Juniper Ltd., a private company, purchased a machine on January 1, 20x6, for $1.35 million. At that time, it was estimated that the machine would have a 10-year life and no residual value. On December 31, 20x9, the firm's accountant found that the entry for depreciation expense had been omitted in 20x7. In addition, management informed the accountant that it planned to switch to straight-line depreciation, starting with the year 2009. At present, the company uses the diminishing balance (20%) method for depreciating equipment. Required - Assuming that this is a change in accounting policy and that the change will result in information that is more relevant to users, prepare the general journal entries the accountant should make at December 31, 2009. The company has a 34% tax rate for 20x6 to 20x9.

Problem 10 Rankin Inc., a private company, acquired the following assets in January 20x5: Equipment: estimated service life, 5 years; residual value, $15,000 $525,000Building: estimated service life, 30 years; no residual value $693,000 The equipment was depreciated using the diminishing balance method (40%) for the first three years for financial reporting purposes. In 20x8, the company decided to change the method of calculating depreciation to the straight-line method for the equipment, but no change was made in the estimated service life or residual value. Management determined that this change would result in financial statements that would provide more relevant information to the users. It was also decided to change the building's total estimated service life from 30 years to 40 years, with no change in the estimated residual value. The building is depreciated on the straight-line method. Net income (depreciation for 20x8 has been calculated on the straight-line basis for both the equipment and buildings) was $385,000 for 20x8 and $380,000 for 20x9. Note that the calculation for depreciation expense for 20x8 and 20x7 for the building was based on the original estimate of a 30-year service life. The company’s tax rate is 36%. Required - (a) Assume that the change to the straight-line method for the equipment is a change in accounting

principle. Calculate the effect of the change to be reported in the restated statement of retained earnings for 2008, and prepare the journal entry to record the change.

(b) Calculate the amount of income reported on the comparative financial statements presented in 20x8. (c) Assume that Rankin had retained earnings of $1.25 million at January 1, 20x7, and $1.63 million at

January 1, 20x8, and that no dividends were declared during either year. Prepare the statement of retained earnings on a comparative basis.

Problem 11 The first audit of the books of Potter Limited was recently carried out for the year ended December 31, 20x8. In examining the books, the auditor found that certain items had been overlooked or might have been incorrectly handled in the past: 1. At the beginning of 20x6, the company purchased a machine for $510,000 (residual value of $51,000)

that had a useful life of six years. The bookkeeper used straight-line depreciation, but failed to deduct the residual value in calculating the depreciation base for the three years.

2. At the end of 20x7, the company accrued sales salaries of $45,000 in excess of the correct amount. 3. A tax lawsuit that involved the year 20x6 was settled late in 20x8. It was determined that the company

owed an additional $85,000 in taxes related to 20x6. The company did not record a liability in 20x6 or 20x7, because the possibility of losing was considered remote. The company charged the $85,000 to retained earnings in 20x8 as a correction of a prior year's error.

4. Potter purchased another company early in 20x4 and recorded goodwill of $450,000. Potter amortized

$22,500 of goodwill in 2004, and $45,000 in each subsequent year. 5. In 20x8, the company changed its basis of inventory costing from FIFO to weighted average cost. The

change's cumulative effect was to decrease net income of prior years by $71,000. The company debited this cumulative effect to Retained Earnings. The average cost method was used in calculating income for 20x8.

6. In 20x8, the company wrote off $87,000 of inventory that it discovered, in 20x8, had been stolen from

one of its warehouses in 20x7. This loss was charged to a loss account in 20x8. Required - Prepare the journal entries in 20x8 to correct the books where necessary, assuming that the 20x8 books have not been closed. Assume that the change from FIFO to weighted average cost can be justified as resulting in more relevant financial information. Assume the company has a tax rate of 25%.

Problem 12 Pagenello Ltd. reported income before income taxes of $176,000, $180,000, and $198,000 in each of the years 20x6, 20x7, and 20x8, respectively. The following information is also available: 1. In 20x8, Pagnello lost a court case in which it was the defendant. The case was a patent infringement

suit, and Pagnello must now pay a competitor $35,000 to settle the suit. No previous entries had been recorded in the books relative to this case as Pagnello management felt the company would win.

2. A review of the company's provision for uncollectible accounts during 20x8 resulted in a determination

that 1% of sales is the appropriate amount of bad debt expense to be charged to operations, rather than the 1.5% used for the preceding two years. Dad debt expense recognized in 20x7 and 20x6 was $25,000 and $17,500, respectively. The company would have recorded $22,500 of bad debt expense under the old rate for 20x8. No entry has yet been made in 20x8 for bad debt expense.

3. Pagnello acquired land on January 1, 20x5, at a cost of $45,000. The land was charged to the equipment

account in error and has been amortized since then on the basis of a five-year life with no residual value. The equipment belongs to Class 8 for CCA purposes (20% rate).

4. During 20x8, the company changed from the diminishing balance method of depreciation for its

building to the straight-line method. Pagnello changed to the straight-line method because its parent company uses straight-line, and making the change therefore results in more relevant information for users of the consolidated statements in their decision-making. Total depreciation under both methods for the past three years is as follows. Dinimishing balance depreciation has been used in 20x8.

Straight-Line Diminishing Balance

20x6 $32,000 $60,00020x7 32,000 57,00020x8 32,000 54,150

5. Late in 20x8, Pagnello determined that a piece of specialized equipment purchased in January 20x5 at a

cost of $54,000 with an estimated life of five years and residual value of $4,000 is now expected to continue in use until the end of 2012 and have a residual value of $2,000 at that time. The company has been using straight-line depreciation for this equipment, and depreciation for 20x8 has already been recognized based on the original estimates.

6. The company has determined that a $225,000 note payable that it issued in 20x6 has been incorrectly

classified on its statement of financial position. The note is payable in annual instalments of $25,000, but the full amount of the note has been shown as a long-term liability with no portion shown in current liabilities. Interest expense relating to the note has been properly recorded.

Required - For each of the accounting changes, errors, or transactions, present the journal entry(ies) that Pagnello needs to make to correct or adjust the accounts, assuming the accounts for 20x8 have not yet been closed. If no entry is required, write "none" and briefly explain why. Assume an income tax rate of 25%. (b) Prepare the entries required in (a) but assume an income tax rate of 25% throughout

SOLUTIONS Problem 1 Using the straight-line method, it will be depreciated over 40 years with an estimated residual value of $50,000. The annual depreciation charge under the straight-line method will be: ($450,000 - 50,000) ÷ 40 years = $10,000 per year. A summary of the actual depreciation charges taken to date and what the depreciation charges using the straight-line method would have been are: Diminishing-Balance Straight -Line Depreciation

Expense Accumulated Depreciation

Depreciation Expense

AccumulatedDepreciation

20x2 $18,000 $18,000 $10,000 $10,00020x3 17,280 35,280 10,000 20,00020x4 16,589 51,869 10,000 30,00020x5 15,925 67,794 10,000 40,000 Assuming a calendar year end, the Morrow Company will present the 20x4 comparative figures along with its 20x5 financial statements. The 20x4 figures will have to be restated as follows: • the 20x4 opening accumulated depreciation balance will have to be reduced by $15,280 ($35,280 - 20,000);

the corresponding adjustment will be made to retained earnings and to the DIT account (assuming a tax rate of 40%):

Accumulated Depreciation $15,280 Deferred Income Tax Account ($15,280 x 40%) $6,112 Retained Earnings ($15,280 x 60%) 9,168

• the 20x4 depreciation expense will have to be restated to $10,000 • the 20x5 depreciation expense will have to be recorded at $10,000 also.

Problem 2 The net book value of the building as at January 1, 20x5, is as follows:

Cost $500,000Less Accumulated depreciation: $500,000 x 5/40 62,500Net book value $437,500

We now want to depreciate this amount over the remaining useful life of the building of 25 years (30 years total less 5 years gone by). The depreciation charge for 20x5 will be $14,300 [($437,500 - 80,000) ÷ 25 years]. Problem 3 First we calculate the difference in the new book value of the asset at January 1, 20x5: NBV using DB: Net book value of machine = $500,000 x 0.803 $256,000

NBV using straight line: Cost $500,000 Less accumulated depreciation - ($500,000 – 100,000) /10 x 3 years 120,000 380,000

Increase in net book value due to accounting change $124,000 The increase in net book value will increase the NBV/UCC temporary difference, thereby resulting in a credit to the DIT account in the amount of $124,000 x 40% = $49,600. The journal entry to record the cumulative effect of the accounting policy change: Accumulated depreciation $124,000 DIT Account 49,600 Retained Earnings 74,400

Problem 4 The adjusting entry as at January 1, 20x5 needs to debit prepaid insurance by $220,000. Also, because this $220,000 was also deducted for income tax purposes we owe CRA $220,000 x 40% = $88,000. The journal entry to correct this error will be: Prepaid insurance $220,000 Income taxes payable $88,000 Retained Earnings 132,000 Problem 5 The depreciation taken in the years 20x3 and 20x4 must be removed: 20x3: $250,000 x 10% = $25,000 20x4: $225,000 x 10% = $22,500 Total = $47,500 Because the company debited the land to the equipment account, CCA was taken in the amount of: 20x3: $250,000 x 10% = $25,000 20x4: $225,000 x 20% = $45,000 Total = $70,000 Because we were not entitled to this claim, we owe CRA: $70,000 x 40% = $28,000. Finally, this transaction created a credit in the DIT Account of $70,000 – 47,500 = $22,500 x 40% = $9,000. The journal entry to correct this error will be: Land $250,000 Equipment $250,000 Accumulated depreciation 47,500DIT Account 9,000 Income taxes payable 28,000 Retained earnings ($47,500 x .6) 28,500

Problem 6 1a) Accounting error: Machine Machine $10,000 Land $10,000

Depreciation Expense (20x5) 800 Retained Earnings (20x1 – 20x4) - ($800 x 4) 3,200 Accumulated depreciation 4,000 The tax effect of this transaction is calculated separately and consists of two

elements: (1) one due to the fact that retrospective CCA can be taken on this asset for the years 20x1 - 20x4 and (2) the deferred income tax element due to the fact that there will be a difference between net book value and UCC at the end of 20x4.

(1) Retrospective CCA 20x1: $10,000 x 20% x ½ $1,000 20x2: $9,000 x 20% 1,800 20x3: $7,200 x 20% 1,440 20x4: $5,760 x 20% 1,152 $5,392 Income taxes receivable ($5,392 x 40%) 2,156 Retained Earnings 2,156 (2) Net book value of asset, Dec 31, 20x4 ($10,000 - 3,200 Accumulated Depreciation) $6,800 UCC at Dec 31, 20x4:

($10,000 - 5,392 Accumulated CCA) 4,608 Temporary difference at Dec 31, 20x4 $2,192 Retained Earnings ($2,192 x 40%) 876 DIT Account 876

b) Accounting error: bonds – failing to amortize the discount on bonds. Yield to maturity on the bonds on the date of acquisition - N = 20, PV = -18,000, PMT = 800, FV = 20,000 I/Y = 4.79% per 6 months Book value of the bonds @ December 31, 20x4: N = 16, I = 4.79%, PMT = 800, FV = 20,000 PV = 18,262 Book value of the bonds @ December 31, 20x5: N = 14, I = 4.79%, PMT = 800, FV = 20,000 PV = 18,415

Investment in Bonds ($18,262 – 18,000) 262 Retained Earnings ($262 x 60%) 157 DIT Account ($262 x 40%) 105 Investment in Bonds ($18,415 – 18,262) 153 Interest revenue 153

c) Accounting error: Inventory Retained Earnings - $7,000 x 60% 4,200 Income taxes receivable - $7,000 x 40% 2,800 Cost of goods sold 7,000

d) The inventory is correct, but last year’s purchases are understated and this year’s purchased are overstated.

Retained Earnings - $11,000 x 60% 6,600 Income taxes receivable - $11,000 x 40% 4,400 Cost of goods sold 11,000 2. Pre-tax income (before restatement) $160,000 Error: Machine (800) Error: Bonds 153 Error: Inventory 7,000 Error: Inventory 11,000 Restated Pre-Tax Net Income $177,353

Problem 7 i. Capitalize truck - Truck $120,000 Retained earnings ($120,000 x 0.65) $78,000 Income Taxes Payable 42,000 Record Depreciation - Net book value of truck as at December 31, 20x8: $120,000 x .803 = $61,440 Depreciation expense for 20x6 - 20x8 = $120,000 - 61,440 = $58,560 Retained earnings 58,560 Accumulated depreciation 58,560 Record taxes receivable on CCA – CCA - 20x6: $120,000 x 30% x 1/2 = $18,000 20x7: $102,000 x 30% = 30,600 20x8: $71,400 x 30% = 21,420 Total CCA = $70,020 Income taxes payable (70,020 x 35%) 24,507 Retained earnings 24,507 Record DIT Account – NBV = $61,440 UCC = $120,000 – 70,020 = $49,980 Retained earnings 4,011 DIT Account ($11,460 x 35%) 4,011 Record 20x9 Depreciation - Depreciation expense ($61,440 x 20%) 12,288 Accumulated depreciation 12,288

ii. Net book value of building at Dec 31, 20x8; Cost $1,500,000 Accumulated depreciation (1,500,000 - 200,000) / 40 x 9 years (292,500) 2 $1,207,500 Depreciation expense in 20x8 should be ($1,207,500 - 100,000) / 26 2 $42,596 Depreciation expense recorded 1 32,500 Adjustment required $10,096 Depreciation expense 10,096 Accumulated depreciation 10,096 Problem 8 Machine X: Cash 2,000Accumulated depreciation--machinery ($3,000 x 5) 15,000 Machinery 15,000 Gain on disposal of machinery 2,000 Machine Y: Depreciation expense 700 Accumulated depreciation—machinery 700Old depreciation expense: [($15,000 - $2,400) = 6 years = $2,100 Accumulated depreciation @ Jan 1, 20x5: $2,100 x 5 years = $10,500 Net book Value: $15,000 - $10,500 = $4,500 New depreciation expense = ($4,500 - $2,400) / 3 years = $700 Machine Z: Depreciation expense 1,500 Accumulated depreciation—machinery 1,500Depreciation Expense = ($15,000 - $600) / 8 years = $1,800 Accumulated depreciation @ Jan 1, 20x5: $1,800 x 5 years = $9,000 Net Book Value = $15,000 - $9,000 = $6,000 New depreciation expense = $6,000 / 4 years = $1,500

Problem 9 Correction of error - Depreciation for…. 20x6: $1,350,000 x 20% = $270,000 20x7: $1,080,000 x 20% = $216,000 20x8: $864,000 x 20% = $172,800 Total = $658,800 The accountant took $270,000 in 20x6 and $216,000 in 20x8. Error = $172,800. Jan 1, 20x9 Retained Earnings ($172,800 x 0.66) $114,048 DIT Account 58,752 Accumulated depreciation $172,800 Accounting Policy Change - Straight Line Annual Depreciation for 20x6 to 20x8: $1,350,000 / 10 x 3 = $405,000 Difference with diminishing balance: $658,800 – 405,000 = $253,800 Jan 1, 20x9 Accumulated depreciation $253,800 Retained Earnings ($253,800 x 0.66) $167,508 DIT Account 86,292

Problem 10 (a) Equipment NBV using DB at Jan 1, 20x8: $525,000 x 0.63 $113,400 Equipment NBV using SL: Cost $525,000 Less Accumulated depreciation (525,000 – 15,000) / 5 x 3 306,000 219,000 Increase in NBV $105,600 Accumulated depreciation $105,600 Retained earnings ($105,600 x 0.64) 67,584 DIT Account 38,016 Retroactive Effect at Jan 1, 2007: Equipment NBV using DB at Jan 1, 2008: $525,000 x 0.62 $189,000 Equipment NBV using SL: $525,000 – 204,000 321,000 $132,000 (b) 20x8 20x7 Net income before taxes before changes: $385,000 / 0.64 | $380,000 / 0.64 $601,563 $593,750

Effect of Accounting Policy Change: Add back DB Depreciation: $525,000 x 0.62 x 0.4 75,600 Less SL Depreciation (102,000)

Effect of change in estimate: Add back depreciation based on original estimates - $693,000 / 30 23,100 Less depreciation based on new estimates - ($693,000 /30 x 27) / 37 (16,857)

Revised NIBT $607,806 $567,350 Taxes @ 36% 218,810 204,246

Revised Net income $388,996 $363,104 (c) Rankin Inc. Statement of Retained Earnings for the years ended December 31 20x8 20x7 Retained earnings, Jan 1, as reported $1,630,000 $1,250,000 Retroactive adjustment for change in amortization

method – net of tax 67,584 84,480

Retained earnings, Jan 1, restated 1,697,584 1,334,480 Net income 388,996 363,104

$2,086,580 $1,697,584Problem 11 1. Accumulated Depreciation ($51,000 / 6 x 2) $17,000 Retained Earnings ($17,000 x 0.75) 12,750 DIT Account ($17,000 x 0.25) 4,250

Accumulated Depreciation ($51,000 / 6) 8,500 Depreciation expense 8,500 2. Sales salaries expense 45,000 Retained earnings ($45,000 x 0.75) 33,750 Income taxes payable ($45,000 x 0.25) 11,250 3. Income tax expense 85,000 Retained earnings 85,000 4. Goodwill (45,000 x 2.5 years) 112,500 Retained earnings (112,500 x 0.75) 84,375 DIT (112,500 x 0.25) 28,125 Goodwill 45,000 Amortization expense – goodwill 45,000 5. No entry necessary 6. Retained earning ($87,000 x 0.75) 65,250 Income taxes receivable ($87,000 x 0.25) 21,750 Inventory loss 87,000

Problem 12 1. Litigation loss $35,000 Litigation liability $35,000 2. Bad debt expense 15,000 Allowance for Doubtful Accounts 15,000 $22,500 / 1.5% x 1% = $15,000 3. (i) record the land - Land $45,000 Equipment $45,000 (ii) remove the depreciation taken (3 years) $45,000 / 5 x 3 = $27,000 Accumulated depreciation 27,000 Retained Earnings 27,000 (iii) record the taxes payable due to having taken CCA on this asset CCA taken in 2005: $45,000 x 20% x ½ $4,500 2006: 40,500 x 20% 8,100 2007: 32,400 x 20% 6,480 19,080 x 40% Income taxes payable $7,632 Retained earnings 7,632 Income taxes payable 7,632 (iv) remove the DIT account that built up on this asset - NBV: $45,000 – 27,000 $18,000 UCC: $45,000 – 19,080 25,920 7,920 x 40% $3,168 dr. Retained earnings 3,168 DIT 3,168

(v) Remove the depreciation expense recorded in 2008: Accumulated depreciation ($45,000 / 5) 9,000 Depreciation expense 9,000 4. SL Depreciation, 2006 – 2007 $ 64,000 DDB Depreciation, 2006 – 2007 117,000 Reduction in NBV required at Jan 1, 2008 $ 53,000 Accumulated depreciation $53,000 Retained earnings ($53,000 x 0.75) 39,750 DIT Account ($53,000 x 0.25) 13,250 Accumulated depreciation ($54,150 – 32,000) 22,150 Depreciation expense 22,150 5. NBV of equipment at Jan 1, 2008 - Cost $54,000 Accumulated depreciation: ($54,000 – 4,000) / 5 years x 3 (30,000) $24,000 Depreciation expense recorded $10,000 Depreciation expense based on new estimate ($24,000 – 2,000) / 5 4,400 Adjustment $5,600 Accumulated depreciation 5,600 Depreciation expense 5,600 6. No entry required. This is an error in classification. No amounts or items are

missing in the financial statements.

BUSI 2002 – Intermediate Accounting II Chapter 22 – Statement of Cash Flow Additional Problems with Solutions Problem 1 The records of Heslop Limited show the following: Statement of Comprehensive Income for the year ended December 31, 20x8 Sales $1,402,300Cost of goods sold 631,100Gross profit 771,200

Depreciation expense 43,200Operating expenses 271,000Interest expense 35,300Investment revenue (1,400)Loss on sale of machinery 16,000

Profit before taxes 407,100Income tax expense 174,000

Profit for the period 233,100

Other Comprehensive Income Unrealized holding gains on FVTOCI Investments $57,600 Realized gain on sale on FVTOCI Investments (16,100) 41,500

Comprehensive Income $274,600 Statement of Financial Position as at December 31, 20x7 20x8 20x7Assets Cash $ 40,000 $ 29,200 FVTOCI investments 226,300 70,700 Accounts receivable (net) 112,500 147,200 Inventory 179,100 187,300 Prepaid rent 4,700 Land 276,000 204,000 Machinery 1,899,000 1,743,900 Accumulated depreciation (801,600) (839,000) Goodwill 890,400 890,400

$2,826,400 $2,433,700 Liabilities and shareholders' equity - Accounts payable $ 139,000 $ 215,200 Salaries payable 46,100 45,500 Taxes payable 21,000 29,000 Bonds payable; 6% 652,200

Bonds payable; 7.2% (face value = $600,000) 588,800 Deferred income taxes 198,900 214,800 Deferred pension obligation 14,900 16,700 Common shares 1,500,000 930,000 Contributed surplus - conversion rights - 83,300 Contributed surplus - stock options 70,000 60,000 Retained earnings 184,200 165,000 Accumulated other comprehensive income: Unrealized holding gains on FVTOCI Investments 63,500 22,000

$2,826,400 $2,433,700 Additional Information - 1. Issued additional 7.2% bonds payable for cash, $588,000. 2. Cash dividends were declared and paid. 3. FVTOCI investments with an original cost of $47,200 were sold in 20x8. The investments had a carrying

value of $50,000 at the beginning of 20x8. Investments were acquired during the year. 4. There is a stock option plan for senior administrative staff. Stock options with a book value of $14,000

were exchanged, along with $37,400 cash, for common shares in 20x8. 5. The 6% bond payable was converted into common shares at the beginning of the fiscal year. 6. Machinery with an original cost of $106,000 was sold. Additional machinery for other activities was

acquired for common shares. 7. Common shares with an average original issue price of $478,000 were retired for $699,200. Required – a. Prepare the Cash Flow from Financing portion of the Statement of Cash Flow. b. Prepare the following as they would appear in Cash Floe from Operations: i. Cash paid for operating expenses ii. Cash paid for interest iii. Cash paid for income taxes

SOLUTION Problem 1 Bonds Payable – 6% Bonds Payable – 7.2% $652,200 $588,000 Issue Conv. 652,200 800 Disc $0 $588,800 Deferred Income Taxes Deferred Pension Oblig $214,800 $16,700 Exp 15,900 Exp 1,800 $198,900 $14,900 Common Shares Cont. Surplus - SO Ret CS.

478,000

$930,000 Beg $60,000 Beg

652,200 83,300

Conv. Conv 14,000 24,000

Comp Exp

SO $70,000 14,000 -CS 37,400 - Cash 261,100 Mach. Cont. Surplus – Conv Rights Conv 83,300 83,300 Conv 1,500,000 $0 Retained Earnings Machinery Ret. CS

221,200

$165,000

Beg

Beg $1,743,900 106,000 Sold

Div 8,800 233,100 Profit New 261,100

16,100

Real Gain

$184,200 End End $1,899,000 a. Cash flow from financing Issue of bonds payable 588,000 Issue of common stock 37,400 Retirement of common shares (699,200) Payment of dividend (8,800)

(82,600)

b. Cash paid for operating expenses Operating expenses (271,000) Increase in prepaid rent (4,700) Increase in salaries payable 600 Decrease in deferred pension obligation (1,800) Compensation expense – stock options 24,000 (252,900) Cash paid for interest Interest expense (35,300) Amortization of bond discount 800 (34,500) Cash paid for income taxes Income tax expense (174,000) Decreases in taxes payable (8,000) Deferred portion (15,900) (197,900)