John Molson School of Business

Department of Accountancy
ACCO 320 – Financial Accounting II
Dr. Kelly F. Gheyara
Midterm Examination, Summer II 2015
Friday, July 24, 2015

Student Name:____________________________ Student ID:_________________ Section:________

Estimated Marks
Time
Question I Restructuring Debt 39 minutes 26 Marks

Question II Liabilities 24 minutes 16 Marks

Question III Other Liabilities 41 minutes 27 Marks

Question IV Asset Related Liabilities 30 minutes 20 Marks

Question V Complex Financial Instruments 46 minutes 31 Marks

TOTAL 180 minutes 120 Marks

Instructions:

1. Make sure you write your name, student ID, and section above on this exam booklet as well as on
each answer booklet you use. There are 5 Questions and 8 Pages which includes present value
tables.

2. There is partial credit available on ALL Questions and so please make sure you show ALL your
work and computations.

3. Allocate your time wisely…You have 3 hours to complete this exam. You MUST STOP all your
work and turn in the exam when the invigilator declares the examination ended.

4. You MUST return (1) this Question booklet document, and (2) your answer booklet/s. Failure to
do so will invoke penalty.

READ EACH PROBLEM AND THINK CAREFULLY.

GOOD LUCK!! I WISH YOU ALL WELL!

Page 1
 QUESTION I - RESTRUCTURING OF DEBT - 26 MARKS

NonTel Inc., needs to renegotiate the terms of its debt with First Montreal Bank. The loan which is
coming due on June 30, 2015 consists of a 12-year, 15% note for $450,000 which was issued at par plus
the accrued interest of $67,500. NonTel is asking its creditor to
a] write off the amount of the accrued interest;
b] lower the interest rate to 6%;
c] reduce the maturity value of the note to $370,000; and
d] extend the term of the note by 7 years.

First Montreal Bank agrees to most of these terms with some modifications. NonTel will have to repay
the new debt set at $370,000 at maturity which will be after four years and not seven years as demanded.
The market rate on June 30, 2015 is 12%. Both parties have adopted IFRS.

Required:

1. Indicate if this transaction a modification [minor restructure] or a settlement [major restructure]?

Support your answer with appropriate reasons and computations.

2. What is the amount at which the debt is to be carried in the books of NonTel under the new terms?
Show all of your work very clearly in order to receive part credit.

3. Prepare all necessary journal entries, on June 30, 2015, on the books of NonTel after the revised
terms of this transaction, take effect.

4. Prepare the necessary journal entries to record the renegotiated debt in the books of First Montreal
Bank.

Page 2
 SOLUTION I - 26 Marks

1. Review the economic substance of the debt renegotiation. Determine if it should be accounted as a
settlement or a modification/exchange related to the old debt. The test is to establish whether there
is a settlement or not revolves around the cash flows.

Present value of current Debt

Face value of existing note $450,000
Accrued interest Owed 67,500
Total PV 517,500

Similarly, Present value of the 6% $270,000 new note at current market rate of 15% :
PV Face Value, 4 years, 15% [0.57175 x 370,000] 211,547.50
PV Interest Instalments, $22,200, 4 years, 15% [2.85498 x 22,200] 63,380.56
Total PV 274,928.06

Since the present value of the future cash flows, 274,928.06, of the new note is less than 90% of the
present value of the existing debt, 517,500, the renegotiated debt is considered to be a settlement.

2. Debt To Be Recorded In The Books Of NonTel

Present value of new debt is to be determined at the current market rate which is 12% .
PV Face Value, 4 years, 12% [0.63552 x 370,000] 235,142.40
PV Interest Instalments, $22,200, 4 years, 12% [3.03735 x 22,200] 67,429.17
Total PV 302,571.57

3. Interest Payable [Given] 67,500

Notes Payable [Given] 450,000
Notes Payable 302,572
Gain on Restructuring of Debt 214,928

4. Bad Debt (Or All’n For Doubtful Acs/s) 242,572

Notes (Loans)/R 242,572

[517,500 - 274,928]

Page 3
 QUESTION II - LIABILITIES - 16 Marks

Jhaz Rocks is a national reseller of music media. As a promotion, it is offering one free music CD for
every five video DVDs purchased during 2014. Each DVD, with a unit selling price of $25 has an
attached coupon serving as a proof-of-purchase on the package. Customers must mail in five such
coupons or proofs-of-purchase in order to receive the free CD. Experience from prior promotional
campaigns suggests that 60% of the coupons or proofs-of-purchase on the DVDs sold will be mailed in.
The cost of the CD to the company is $7.00 and it sells similar music CDs to customers at an average
price of $12.00 each. In 2014, 280,000 DVDs were sold. The promotion programme will end on March
31, 2015 and coupons received after that date will not be accepted.

Required:

1, Determine the amount that will be reported as a promotional expense by Jhaz in its 2014 income
statement?

2. Assuming that 45,000 proofs-of-purchase seals were submitted by customers to claim the free CDs,
determine the amount for premium liability that Jhaz would report on its balance sheet as at
December 31, 2014.

3. Prepare the appropriate journal entries in [1] and [2], in proper format, to record the effects of the
two transactions.

Page 4
 SOLUTION II - 16 Marks

1] $235,200 [280,000 x 0.6 x 0.20 x $7]

2] $172,200 [{(280,000 x 0.6) - 45,000} x 0.20 x 7]

3] Premium Expense 63,000

CD Inventory 63,000
[(45,000 / 5) X $7.00]

Premium Expense 172,200

Estimated Liability for Premiums 172,200
[As Above]

OR

Premium Expense 235,200

Estimated Liability for Premiums 235,200

Estimated Liability for Premiums 63,000

CD Inventory 63,000
[As Above]

Page 5
 QUESTION III - OTHER LIABILITIES - 27 Marks

Section A - 18 Marks

Montreal Auto Parts, Inc., [MAP] is a regional company manufacturing several parts, as per given
specifications, for all major automobile manufacturers. It has three manufacturing plants and four
materials processing plants located within Quebec and employs 500 personnel. You have applied for the
position of Chief Financial Accountant and are being interviewed for the position. The CFO has asked
you to advice her on the proper accounting treatment for each of the three situations, as stated below, in
preparing the company’s December 31, 2014 financial statements based on the requirements of ASPE.

(i) The company pays its employees every two weeks on a Friday. For December, the last payment
date was December 24. For the following week upto December 31, the company estimates the
payroll expenses to amount to $408,600 which will be paid at the end of the first week of January,
2015.

(ii) The company’s Steel Melting plant is not insurable because of special types of possible injuries due
to fire or local explosion. The management has implemented some very stringent safety procedures
and as a result, there were no injuries during 2014. But the management feels certain that in the
following years, the company may not be so fortunate to enjoy other accident free years. The CFO
is uncertain how these potential losses in the following year should be reported in the financial
statements of 2014.

(iii) The company had a practice to invite the families of workers for a visit to the plant on Family Day
and treat them to a lunch and drinks. Unfortunately, in 2014, two young children were injured
during this visit. The related families sued the company for negligence and claimed a total of $14
million as compensatory damages. The company’s lawyer is of the opinion that the company is
most likely to lose the suit and that the judgement costs would possibly range between $200,000
and $950,000.

Required:

1] For each of the above three situations (i) to (iii), prepare the appropriate journal entry/entries to
record the loss as at December 31, 2014, OR explain why an entry should not be recorded.

2] Explain briefly, how each of the above three stated transactions would be reported in the financial
statements under private enterprise GAAP.

3] Ignore the information given in the above three stated cases. In general, briefly state how the
requirements for Contingent Losses would be different under the current and proposed IFRS rules
from the rules under private enterprise GAAP.

Page 6
Section B - 9 Marks

MAP offers a two-year warranty covering replacement and labour for all their parts sold. In 2014, the
company recorded sales of $27,000,000 in manufactured part. Based on prior performance data, the
management has estimated the likely warranty costs to be 1.5% of the sales in the first year of sales, 3%
in the second year.

MAP uses the Expense Approach to account for warranty costs. It incurred actual warranty expenditures
of $196,000 in 2014 and $386,000 in 2015.

Required:

1, Prepare in proper format, the journal entries to record all warranty related transactions and
adjustments for 2014.

2. Determine the amounts reported as Warranty Expenses in 2014 and 2015 on the given sales.

3. How would the warranty be reported on the Balance Sheet, 2014 and determine the amount to be so
reported.

Page 7
 SOLUTION III - 27 Marks
Section A - 18 Marks
(1i) Payroll Expenses 408,600
Payroll Costs Payable 408,600
[Wages, Salaries and other similar terms are acceptable]

(1ii) Even though MP’s plant is uninsurable due to high risk and possibly sustained repeated losses in the
past, as of the balance sheet date no assets have been impaired or liabilities incurred nor is an amount
reasonably estimable.* Therefore, this situation does not satisfy the criteria for recognition of a loss
contingency.* Hence no JE would be required.**

(1iii) It is likely a loss and liability have been incurred and a reasonable estimate can be made of the
amount. The loss and liability should be recorded as follows:
Loss From Accident 200,000
Liability For Accident 200,000

(2i) Under Private Enterprise GAAP, the payroll Expenses would be accounted for in the Income
Summary* while the Payroll Costs payable would be reported in the Balance Sheet* as Current
Liabilities.*

(2ii) Unless a casualty has occurred or there is some other evidence to indicate impairment of an asset
prior to the issuance of the financial statements, there is no disclosure required relative to a loss
contingency.*
The absence of insurance does not of itself result in the impairment of assets or the incurrence of
liabilities. Expected future injuries to others or damage to the property of others, even if the amount is
reasonably estimable, does not require recording a loss or a liability.**
The cause for loss or litigation or claim must have occurred on or prior to the balance sheet date and
the amount of the loss must be reasonably estimable in order for a loss contingency to be recorded.**
Disclosure is required when one or both of the criteria for a loss contingency are not satisfied and
there is a reasonable possibility that a liability may have been incurred or an asset impaired, or, it is
probable that a claim will be asserted and there is a reasonable possibility of an unfavourable
outcome.**

(2iii) PE GAAP requires that, when some amount within a likely range appears at the time to be a better
estimate than any other amount within that range, that amount be accrued. When no amount within
the range is a better estimate than any other amount, the dollar amount at the low end of the range is
accrued and the dollar amount of the high end of the range is disclosed.
Since the information indicates that it is likely that a liability has been incurred at December 31,
2010, and a range of possible amounts can be reasonably determined, the criteria for recording a
liability are met. In this case, therefore, the company would report a liability of $200,000 at
December 31, 2010, as above, along with other particulars related to the case.
Note to the Financial Statements
The corporation is a defendant in a personal injury suit for $14,000,000. The corporation is charging
the year of the accident with $200,000 in estimated losses, which represents the amount the company
estimates will likely be awarded within a range of $200,000 to $950,000.

Page 8
(3) It must first be determined whether an obligation exists at the reporting date. Liabilities can arise
only from unconditional (or non-contingent) obligations.* Uncertainty about the amounts that
might be payable in the future is taken into account in the measurement of the liability, not its
existence. *
IFRS requirements would be similar to the PE GAAP except that IFRS uses the criterion of
“probable” to determine the chance of occurrence of a confirming future event and which is
interpreted to mean “more likely than not.”* This is a somewhat lower standard than the “likely”
required under private enterprise standards.* If the amount cannot be measured reliably, no
liability is recognized under IFRS.* However, IFRS requires the best estimate and an “expected
value” method to be used to measure the liability.* This approach assigns weights to the possible
outcomes according to their associated probabilities when a range of possible amounts is
available.*

Section B - 9 Marks

1] Warranty Expense 196,000

Miscellaneous Accounts [Any Appropriate title] 196,000

Warranty Expense 1,019,000

Estimated Liability Under Warranties 1,019,000
[(27,000,000 x 0.045) - 196,000]

OR
Warranty Expense 1,215,000
Estimated Liability Under Warranties 1,215,000

Estimated Liability Under Warranties 196,000

Miscellaneous Accounts 196,000

2] 2011: $3,375,000 [(3,000 x 9,000 x .125)]

2012: Zero

3] $1,019,000 Reported as Current Liabilities [(3,000 x 9,000 x .045) - 196,000]

Page 9
 QUESTION IV - ASSET RELATED LIABILITIES - 20 Marks

Roketz-N-Thingz is a newly incorporated company. Its primary business objective is directed towards
the exploration of faraway planets and it has accepted a plan to land the first man/woman on Pluto within
the next 10 years. Some two years ago, it leased over 1,000 acres of land in Chicoutimi, Quebec for
setting up a rocket testing and launching site. It further constructed on this site, five launching pads, each
at a cost of $1,000,000 and capitalized the total cost to a fixed asset, Launch Pad Equipment. The land
lease and the equipment have a life of 20 years. The government of Quebec placed several conditions on
the company in its lease contract. One of the conditions of the lease was to dismantle all equipment and
restore the land once the lease contract ended. The company commenced its operations on January 1,
2016 and recorded an amount representing the present value of the future restoration costs amounting to
$1,800,000. It has decided to use the current market rate of 3% as the effective discount rate. The
company amortizes all assets and any capitalized asset restoration costs on a straight line basis. The
company’s year ends on December 31 and it has adopted ASPE.

Required:

1. Provide the journal entry required to record the cost of restoration recorded on January 1, 2016.

2. Provide the journal entry required to record the depreciation expense incurred for the Launch Pad
Equipment for 2016.

3. Provide the journal entry required to record the annual interest accruing on the Equipment
Restoration Obligation for 2017.

4. Determine the balance in the Equipment Restoration Obligation Account on December 31, 2035.

5. Assume for THIS QUESTION ONLY that the company expects at the end of 2016, to incur, due
to the launching operations in 2016, additional future costs $500,000 towards restoration. This
additional future cost is not related to the initial construction of the launching equipment but is due
to the launching operations. Provide the journal entry to record this additional cost on December
31, 2016.

6. Determine the amount of the revised depreciation expenses for 2017.

Page 10
 SOLUTION IV - 20 Marks

1. Provide the journal entry required to record the cost of restoration recorded on January 1, 2016.

PV 1,800,000, 20, 3% : (1,800,000 x 0.55368) = 996,624

Equipment Restoration Obligation 996,624

Launch Pad Equipment 996,624

2. Provide the journal entry required to record the depreciation expense incurred for the Launch Pad
Equipment for 2016.

(5,000,000 + 996,624) / 20 = $299,831

Amortization Expense 299,831

Acc. Amortization - LPE 299,831

3. Provide the journal entry required to record the annual interest accruing on the Equipment
Restoration Obligation for 2017.

Interest for 2016: (996,624 x 0.3) = 29,899

Interest for 2017: (996,624+ 29,899) x 0.03 = $30,796

Accretion Expense 30,796

Equipment Restoration Obligation 30,796

4. Determine the balance in the Equipment Restoration Obligation Account on December 31, 2035.

Balance: $1,800,000

5. Assume for THIS QUESTION ONLY that the company expects at the end of 2016, to incur, due
to the launching operations in 2016, additional future costs $500,000 towards restoration. This
additional future cost is not related to the initial construction of the launching equipment but is due
to the launching operations. Provide the journal entry to record this additional cost on December
31, 2016.

PV 500,000, 19, 3% : (500,000 x 0.57029) = 285,145

Launch Pad Equipment 285,145

Asset Retirement Obligations 285,145

6. Determine the amount of the revised depreciation expenses for 2017.

(5,000,000 + 996,624 - 299,831 + 285,145) / 19 = $314,839

Page 11
 Question V - Complex Financial Instruments - 31 MARKS

Prepare all required journal entries, in proper format, to record the transactions for each of the unrelated
situations described below. Assume that IFRS was being used in all cases.

1. On January 1, 2011, the Autumn Leafs Corporation issued 14% 16-year convertible bonds with par
value of $8,000,000. The market rate on the date of issue was 10% . In order to make this bond
issue more attractive in the market, the company had attached three warrants to each $1,000 par
value bond. Each warrant entitled the holder to purchase one common share for $40. Similar
warrants were being traded at $4.50 each. The bonds were convertible into 320,000 no par
common shares and an additional charge of $5 per bond was added to the bond price for acquiring
the conversion rights. The issue price of these bonds without the warrants and conversion rights, as
determined by the bonds’ stated cash flows, represented their fair market value. The company thus
issued this package deal at a price which included the bonds determined as per their cash flows plus
the values of the warrants and the conversion rights. Interest was payable semi-annually on June
30 and December 31, the company had adopted IFRS and followed a December 31 year end.

On March 1, 2012, 60% of all warrant holders exercised their rights to purchase the company’s
common shares when the market price was $48.30 for each share.

On July 1, 2014 after accounting for all accrued interest, 3,200 of the outstanding bonds were called
in for conversion.

Required:

1. Determine the amount at which the bonds would be capitalized on January 1, 2011 (This would be
the market price based upon their stated cash flows). Be sure to show me your computations
clearly in order to receive part credit for your work.

2. Prepare the journal entry on January 1, 2011 to record the issue of the bonds.

3. Prepare a journal entry to record the interest on December 31, 2011.

4. Show how the bonds would be reported on the company’s balance sheet on December 31, 2011.

5. Prepare the journal entry to record the exercising of the warrants on March 1, 2012.

6. Prepare the journal entry to record the conversion of the bonds on July 1, 2014

HINT: Preparing A Partial Amortization Table Would Be Extremely Helpful

The End - - - Time To Party

Page 12
 SOLUTION V - 31 Marks

1. Determine the amount at which the bonds would be capitalized on January 1, 2011 (This would be
market price based upon their stated cash flows).
PV of Par Value (8,000,000, 32P, 5%) = 8,000,000 x 0.20987 = $ 1,678,960
PV of Interest @ 7% (560,000, 32P, 5%) = 560,000 x 15.80268 = $ 8,849,500
Market Value of Bonds $10,528,460

2. Prepare the journal entry on January 1, 2011 to record the issue of the bonds.
Total Issue Price
Bond FMV $10,528,460
Warrants: 8,000 x 3 x 4.50 108,000
Conversion: 8,000 x 5 40,000
Total Issue Price $10,676,460

Cash 10,676,460
Bonds Payable 10,528,460
Contribution Surplus - W 108,000
Contribution Surplus - C 40,000

3. Prepare a journal entry to record the interest on December 31, 2011.

Interest Xp 524,744
Bonds Payable 35,256
Cash 560,000

4. Show how the bonds would be reported on the company’s balance sheet on December 31, 2011.
Liabilities
Current - Bonds Payable 75,889
[37,019 + 38,870]
Non Current - Bonds Payable 10,383,739

5. Prepare the journal entry to record the exercising of the warrants on March 1, 2012.
Cash 576,000
Contribution Surplus - W 64,800
Common Stock 640,800
[8,000 x 3 x 40 x 0.6] = 576,000; [108,000 x 0.6] = 64,800;

6. Prepare the journal entry to record the conversion of the bonds on July 1, 2014
Bonds Payable 4,102,030
Contribution Surplus - C 16,000
Common Stock 4 ,118,030
[As Per Amortization Table] = [10,255,076 x 0.4] = 4,102,030; [40,000 x 0.4] = 16,000;

Page 13
Bond Amortization Table

Date Cash @ 7% Interest Xp @5% Amortization Balance

Jan. 1, 11 10,528,460

June 30, 11 560,000 526,423 (33,577) 10,494,883

Dec. 31, 11 560,000 524,744 (35,256) 10,459,627

June 30, 12 560,000 522,981 (37,019) 10,422,609

Dec. 31, 12 560,000 521,130 (38,870) 10,383,739

June 30, 13 560,000 519,187 (40,813) 10,342,926

Dec. 31, 13 560,000 517,146 (42,854) 10,300,072

June 30, 14 560,000 515,004 (44,996) 10,255,076

Dec. 31, 14 560,000 512,754 (47,246) 10,207,830

Page 15