UNIVERSITY OF TORONTO
JOSEPH L. ROTMAN SCHOOL OF MANAGEMENT

MGT220H – FINANCIAL ACCOUNTING II
TERM TEST – MONDAY, JULY 23, 2001

Duration: 1 ½ hours.
Aid Allowed:  Non-programmable calculator. Programmable calculators will be reset.

INSTRUCTIONS:

Part 1.  Multiple choice questions.  Answers to multiple choice questions are to be recorded on the mark sense sheet IN PENCIL.

TIME WILL NOT BE GIVEN AT THE END OF THE TEST TO FILL IN THE
COMPUTER SHEET.  THE QUESTION PAPER WILL NOT BE MARKED.  ONLY
THE COMPUTER SHEET WILL BE GRADED.

Parts 2 and 3.  Write your answers in the space provided on the test paper.  This part
Of the test should be written in ink.  Only papers written in ink, and not using white-out,
Will be considered for remarking.  Papers must be submitted before leaving class on
The day that they are returned to be considered for remarking.  Papers will be remarked
In total.  The mark may go up, go down, or remain the same.

Problem.  Show and label all calculations to obtain maximum marks.

Mini-case.  Your recommendation(s) must be in keeping with GAAP.

                                                                                                               MARKS

TABLES ATTACHED                                                                       1. _________________

2. _________________

3. _________________

TOTAL   __________________

NAME  _____________________________

STUDENT NUMBER  ___________________                     

PART 1.    (15 marks)

1.	When computing basic earnings per share, dilutive securities are

     a. ignored.
     b. recognized whether they are dilutive or anti-dilutive.
     c. recognized only if they are anti-dilutive.
     d. recognized only if they are dilutive.
     e. none of these

  2. With respect to the computation of earnings per share, which of the
     following would be most indicative of a simple capital structure?

     a. Common shares, preferred shares, and convertible securities
        outstanding in lots of even thousands.
     b. Earnings derived from one primary line of business.
     c. Ownership interest consisting solely of common shares.
     d. None of these.

  3. Which of the following elements of financial statements is NOT a
     component of net income?

     a. Revenues.
     b. Distributions to owners.
     c. Losses.
     d. Expenses.
     e. None of these.

  4. Net income

     a. excludes certain gains and losses that result from incidental
        events.
     b. includes gains and losses from peripheral transactions.
     c. excludes extraordinary gains and losses.
     d. includes distributions of equity.
     e. none of these.

  5. Stately Corporation made a very large arithmetical error in the
     preparation of its year-end financial statements by improper
     placement of a decimal point in the calculation of depreciation.
     The error caused the net income to be reported at almost double the
     proper amount.  Correction of the error when discovered in the
     following year should be treated as

     a. an increase in depreciation expense for the year in which the
        error is discovered.
     b. a component of income for the year in which the error is dis-
        covered, but separately listed on the income statement and fully
        explained in a note to the financial statements.
     c. an extraordinary item for the year in which the error was made.
     d. an adjustment to retained earnings to correct the error in the
        previous period.
     e. none of these.

  6. Spike Company, with an applicable income tax rate of 30%, reported
     net income of $175,000.  Included in income for the period was an
     extraordinary loss from flood damages of $30,000 before deducting
     the related tax effect.  The company's income before income taxes
     and extraordinary items was

     a. $205,000.
     b. $250,000.
     c. $280,000.
     d. $196,000.
     e. none of these.

  7. Rogo Corp.'s trial balance reflected the following account balances
     at December 31, 1998:
     Accounts receivable (net)                                                   $16,000
     Short-term investments                                                         5,000
     Accumulated depreciation on equipment and furniture          15,000
     Cash                                                                                       11,000
     Inventory of merchandise                                                     30,000
     Equipment and furniture                                                        25,000
     Patent                                                                                      4,000
     Prepaid expenses                                                                      1,000
     Land held for future business site                                          18,000
     
     In Rogo's December 31, 1998 balance sheet, the current assets total
     Is

     a. $81,000
     b. $73,000
     c. $67,000
     d. $63,000
     e. none of these.

  8. When the current ratio is greater than 1:1, the use of a current
      asset to pay a current liability will result in

      a. an increase in working capital.
      b. a decrease in working capital.
      c. an increase in the current ratio.
      d. a decrease in the current ratio.
      e. none of these

  9. Convertible bonds

     a. have priority over other indebtedness.
     b. are usually secured by a first or second mortgage.
     c. pay interest only in the event earnings are sufficient to cover
        the interest.
     d. may be exchanged for equity securities.
     e. none of these.

 10. Present value is

     a. the value now of a future amount.
     b. the amount that must be invested now to produce a known future
        amount.
     c. always smaller than the future amount.
     d. all of these.
     e. none of these.

 11. Which table would you use to determine how much you would need to
     have deposited three years ago at 10% compounded annually in order
     to have $1,000 today?

     a. Amount of 1 or present value of 1.
     b. Amount of an annuity due of 1.
     c. Amount of an ordinary annuity of 1.
     d. Present value of an ordinary annuity of 1.
     e. none of these.

 12. Which of the following transactions would require the use of the
     present value of an ANNUITY DUE concept in order to calculate the
     present value of the asset obtained or liability owed at the date of
     incurrence?

     a. A capital lease is entered into with the initial lease payment
        due upon the signing of the lease agreement.
     b. A capital lease is entered into with the initial lease payment
        due one month subsequent to the signing of the lease agreement.
     c. A ten-year, 8% bond is issued on January 2 with interest payable
        semi-annually on July 1 and January 1 yielding 7%.
     d. A 10-year, 8% bond is issued on January 2 with interest payable
        semi-annually on July 1 and January 1 yielding 9%.
     e. None of these.

 13. Rice Co. had 300,000 common shares issued and outstanding at
     December 31, 1997. No common shares were issued during 1998. On
     January 1, 1998, Rice issued 200,000 nonconvertible preferred
     shares. During 1998, Rice declared and paid $75,000 cash dividends
     on the common shares and $60,000 on the preferred shares. Net income
     for the year ended December 31, 1998 was $330,000. What should be
     Rice's 1998 earnings per common share?

     a. $1.10.
     b. $0.90.
     c. $0.85.
     d. $0.65.
     e. none of these.

 14. Generally accepted accounting principles

     a. are fundamental truths or axioms that can be derived from laws
        of nature.
     b. derive their authority from legal court proceedings.
     c. derive their credibility and authority from general recognition
        and acceptance by the accounting profession.
     d. have been specified in detail in the CICA conceptual framework.
     e. none of these.

 15. A generally accepted method of valuation is

     a. marketable securities at market value.
     b. accounts receivable at estimated amount collectible.
     c. inventories at current cost.
     d. all of these.

PART 2. (10 marks)

Robyn Hood, a bank robber, is worried about her retirement.  She decides to start a savings account. Robyn deposits annually her net share of the “loot”, which consists of $70,000 per year, for three years, beginning January 1, 1996.  Robyn is arrested on January 4, 1998 (after making the third deposit) and spends the rest of 1998 and most of 1999 in jail.  She escapes in September of 1999 and resumes her savings plan with semiannual deposits of $25,000 each, beginning January 1, 2000.  Assume that 
the bank’s interest rate is 9% compounded annually from January 1, 1996 through January 1, 1999, 
and 12% semiannually thereafter.

Instructions

Draw a time line for this problem, labeling dates, and cashflows. 

When Robyn retires on January 1, 2003 (six months after her last deposit), what will be the balance in her savings account?

Soln:

Future amount of 70,000 annuity due 1/1/99:
70,000 [ f (3 periods, 9%) x 1.09] = 70,000 x [3.57313] = 250,119.10

Future amount of 250,119.10 on 1/1/03:
250,119.10 x [ f (8 periods, 6%)] = 250,119.10 x 1.59385 = 398,652.33

Future amount of 25,000 annuity due on 1/1/03:
25,000 x [ f (6 periods, 6%) x 1.09] = 25,000 x 7.39384 = 184,846

FV= 398,652.33 + 184,846 = 583, 498.33

PART 3. (10 marks)

Last Saturday morning you woke early and decided to visit the St. Lawrence Market.  It is so interesting at 5 am on Saturday.  Shoppers ranged from bargain hunters to partygoers on their way home from after hours clubs.  The dress ranged from shorts and T’s to formal attire.  When you finished shopping you went to a local restaurant frequented by the early morning shoppers.  While you were waiting for your omelet and coffee you opened your magazine and looked for an interesting article.  But then you became fascinated with the conversation at the table behind you.

Gent:	“It’s been so very difficult this year.  We’ve reviewed everything over the past couple of months.  Finally this week we thought we had it made.  We were going to beat the street – one of a few to manage to do so this year.  Then, yesterday, we had a low blow.”

Lady:	“What happened?”

Gent:	“First, let me tell you about the new, young accountant we hired last spring.  He’s absolutely brilliant.  He’s the one with the know how when it comes to managing earnings.  I’m going to recommend him for promotion and see that he is included when it comes to giving out bonuses.  

	“He worked with the lawyers and was able to convince them that a pending lawsuit held little merit.  Originally, they suggested we should accrue several million dollars.  Then when he pointed out that the company suing us had little hope of surviving long enough to get us into court, they backed off.

	“We had some old inventory that could never be sold.  He suggested that we donate it to a church for a donation receipt.  They gave us a receipt for our cost.”

Lady:	“So how does that help?  You will have to write off the inventory at cost, and the donation receipt will only offset that cost.

Gent:	“The inventory was going to be written off.  The donation deduction will offset that cost so, in effect, there is zero effect.  The write off was several hundred thousand dollars.

	“He reviewed our accounting policies and estimates.  Wisely, he recommended we not make any changes to our policies; he said it could raise questions, and I agree.  However, by extending the estimated useful lives of all our assets by just a year or two and eliminating most estimated salvage values, he got our EPS two cents above analysts expectations.”

Lady:	“Sounds good.  So what happened to burst the bubble?”

Gent:	“This young man is a star waiting to be born, and I plan to help him.  He watches all the business shows on TV and reads all the business papers.  He came to me yesterday with some disturbing news.  He spotted a two-sentence item in the Globe yesterday morning.  The company suing us has been awarded a large contract.  Their bank has given them a large loan backed by this contract.  It looks like they will survive after all.

	“I asked him if the lawyers knew about this.  He told me he hadn’t had a chance to tell them about it yet.  I suggested we leave it to them to find out.  I told him about my plans for a promotion and bonus for his good work.  I think he will work with me on this.”

Lady:	“I certainly hope so.  If not, you won’t do very well when you issue the new series of shares in October!”

Gent:	“Let’s get out of here.  I need some sleep.”

On Monday morning your firm sent you to a new client, Brash and Sassy.  To your surprise, “Gent” met you at the reception and took you to meet the new young accountant.  Another surprise – the accountant was a friend from university.  You had graduated with him in June.

Required:  Assume the role of auditor and analyse the case.  Put yourself in the shoes of all parties.  Consider any ethical issues.  Analyse the issues in the case.  Your recommendations must be in keeping with GAAP.  Remember to discuss GAAP for all issues.

A solution 

Overview:

Company
•	public company – company plans to issue new shares in a few months
•	nothing known about the company

Industry – unknown

Users:

Management (A)
Shareholders (C/A)
Creditors (C)

Role:	Auditor (C)

FRO:	Conservative / Aggressive

Constraints:   GAAP – public company being audited

Players:

Gent:	wants his bonus and to keep his job.  Is offer of promotion and bonus more of a bribe to the accounting student?
Accounting student:  wants promotion and bonus and continued mentoring
Auditor:  wants fair reporting.  Ethically, the auditor should report the conversation overheard to his / her supervisor before he begins work on the audit.  Should auditor tell the friend about the conversation?  No.  The friend will have to make his/her own decisions about how to live life.

Issues:

Contingent Liability:

GAAP:	If amount can be reasonably estimated and if outcome is anticipated that company will lose the suit, they must accrue the amount.  If the amount or outcome cannot be reasonably determined, note disclosure is required unless it is highly likely that they will win.

Since the lawyers had recommended they accrue, the amount and outcome must be reasonably estimable.  Even if the suing company becomes insolvent, creditors and others have the right to the amount that would be awarded.  This does not mean that the litigation would not go forward.  Brash and Sassy should accrue even if the suing company will not survive.

Subsequent Event:

The announcement that the suing company has survived should not be kept from the lawyers.
They agreed to not insist on accruing the contingent liability based on the fact that the other company would likely not be around.

Recommendation:  Accrue the contingent liability

Inventory for donation receipt:  

Presumably the church had some use for the inventory.  If so, you would write off the inventory and record the donation

Change of estimates:

GAAP:  Estimates should be changed when new information indicates that a change is required.  These changes are prospective; that is, they are not treated retroactively.  

Changes in estimates should not be made simply to increase earnings.  Each asset should be reviewed with regard to estimated life and salvage.  Where warranted, changes should be made.  However, it is difficult to dispute a 1 year increase.  On the other hand, it would be strange to increase the life of every asset for a year or two.

Recommendation:	Change estimates only where it makes sense to do so.