Solution to Mid-Term Exam

ADM 4348M Winter 2011

SPECIAL TOPICS IN FINANCIAL ACCOUNTING
March 1, 2011
DMS 4140 17:30-20:30

Professor : Sheldon Weatherstone

Duration: 3 hours

Instructions
1. Non-programmable calculators are permitted, but you cannot share calculators.
2. Books and notes are not permitted.
3. Please do not ask the professor or the invigilator to explain or interpret questions.
State any assumptions you feel are necessary.
4. Write your answers in the booklet provided.
5. Hand back the signed examination copy with your exam booklet(s).

STUDENT NAME: __________________________________________

STUDENT # : ________________________
Statement of Academic Integrity
The School of Management does not condone academic fraud, an act by a student that may result in a false
academic evaluation of that student or of another student. Without limiting the generality of this definition,
academic fraud occurs when a student commits any of the following offences: plagiarism or cheating of any
kind, use of books, notes, mathematical tables, dictionaries or other study aid unless an explicit written note
to the contrary appears on the exam, to have in his/her possession cameras, radios (radios with head sets), tape
recorders, pagers, cell phones, or any other communication device which has not been previously authorized
in writing.
Statement to be signed by the student:
I have read the text on academic integrity and I pledge not to have committed or attempted to commit
academic fraud in this examination.
Signed:______________________________________

Note: an examination copy or booklet without that signed statement will not be graded and will receive a final
exam grade of zero.

QUESTION 1 (40 marks)

The following information is available for the Flintstone Corporations pension plan.
Flintstone reports under private enterprise accounting standards.
2011
$ 10,000
175,000
165,000
35,000
7%
8%
44,000
24,000

Accrued pension liability 1/1/2011

Accrued benefit obligation 1/1/2011
Fair value of plan assets 1/1/2011
Current service cost, end of year
Discount rate and expected return
Actual return on plan assets
Contributions, end of year
Benefits paid to retirees, end of year

2012
$47,250
10%
6%
44,000
26,000

On January 1, 2011, Flintstone Corp. amended its pension plan, resulting in past service
costs with a present value of $100,000. The amendment of the pension plan is expected to
provide future benefits up to the average eligibility date which is ten years from now.
There are no unamortized actuarial gains of losses as at 1/1/2011. There are also no
actuarial gains or losses on the accrued benefit obligation due to changes in actuarial
assumptions during the period under review (i.e. no actuarial re-evaluations were
conducted as Flintstone commits to having them done only every three years).
Instructions:
(a) Identify the plans funding status and the asset or liability reported on the
December 31, 2011 and 2012 balance sheets assuming that Flintstone Corp.
accounts for its pension with the deferral and amortization approach under PE
GAAP.
(b) Calculate the pension expense for 2011 and 2012 assuming that Flintstone Corp.
accounts for its pension with the deferral and amortization approach under PE
GAAP.
(c) Identify the plans funding status and the asset or liability reported on the
December 31, 2011 and 2012 balance sheets assuming that Flintstone Corp.
accounts for its pension with the immediate recognition approach.
(d) Calculate the pension expense for 2011 and 2012 assuming that Flintstone Corp.
accounts for its pension with the immediate recognition approach.
(e) Which method results in a better measure of expense over the two year period?
(f) Which method results in a better measure of the funding status on the balance
sheet?

Solution:
(a)
2011
Accrued benefit obligation, 1/1/11
Past service cost
Interest cost ($275,000 x 7%)
Current service cost
Benefits paid out

$175,000
100,000
275,000
19,250
35,000
(24,000 )

ABO, 12/31/11

$305,250

Plan assets, 1/1/11

Expected return on assets ($165,000 x 7%)
Actuarial gain ($165,000 x (8% - 7%))
Contributions
Benefits paid out

$165,000
11,550
1,650
44,000
(24,000 )

Plan assets, 12/31/11

$198,200

Accounts reported on the balance sheet:

Accrued benefit obligation
Plan assets at fair value

$(305,250)
198,200

ABO in excess of plan assets (under-funded)

Unamortized past service cost (100,000-10,000)
Unamortized Actuarial Gain
Accrued pension liability (10,000 + 52,700 44,000)

(107,050)
90,000
(1,650)
($18,700)

2012
Accrued benefit obligation, 1/1/12
Interest cost ($305,250 x 10%)
Current service cost
Benefits paid out

$305,250
30,525
47,250
(26,000 )

ABO, 12/31/12

$357,025

Plan assets, 1/1/12

Expected return on assets ($198,200 x 10%)
Actuarial Loss ($198,200 x (6% - 10%))
Contributions
Benefits paid out

$198,200
19,820
(7,928)
44,000
(26,000 )

Plan assets, 12/31/12

$228,092

Accounts reported on the balance sheet:

Accrued benefit obligation
Plan assets at fair value

$(357,025)
228,092

ABO in excess of plan assets (under-funded)

Unamortized past service cost (90,000 10,000)
Unamortized Actuarial Loss ((1,650) + 7,928)
Accrued pension liability (18,700 + 67,955 - 44,000)

(128,933)
80,000
6,278
($42,655)

Corridor Method:
Unamortized Actuarial (Gain)/Loss at 1/1/2011
10% of ABO (larger than Plan Assets) at 1/1/2011
Surplus to amortize

0
17,500
0

Unamortized Actuarial Gain at 1/1/2012

10% of ABO (larger than Plan Assets) at 1/1/2012
Surplus to amortize

1,650
30,525
0

(b)
Pension expense 2011:
Current service cost
$ 35,000
Interest on accrued benefit obligation
19,250
Expected return on plan assets
(11,550)
Amortization of past service cost ($100,000 / 10)
10,000
Amortization of Actuarial (Gain)/Loss (see corridor method above)
0
$52,700
Pension expense 2012:
Current service cost
Interest on accrued benefit obligation
Expected return on plan assets
Amortization of past service cost ($100,000 / 10)
Amortization of Actuarial Gain (see corridor method above)

$47,250
30,525
(19,820)
10,000
0
$ 67,955

(c)
2011
Accrued benefit obligation, 1/1/11
Past service cost
Interest cost ($275,000 x 7%)
Current service cost
Benefits paid out

$175,000
100,000
275,000
19,250
35,000
(24,000 )

ABO, 12/31/11

$305,250

Plan assets, 1/1/11

Expected return on assets ($165,000 x 7%)
Actuarial gain ($165,000 x (8% - 7%))
Contributions
Benefits paid out

$165,000
11,550
1,650
44,000
(24,000 )

Plan assets, 12/31/11

$198,200

Accounts reported on the balance sheet:

Accrued benefit obligation
Plan assets at fair value

$(305,250)
198,200

ABO in excess of plan assets (under-funded)

Unamortized past service cost
Unamortized Actuarial Gain
Accrued pension liability (10,000 + 141,050 44,000)

(107,050)
0
0
($107,050)

2012
Accrued benefit obligation, 1/1/12
Interest cost ($305,250 x 10%)
Current service cost
Benefits paid out

$305,250
30,525
47,250
(26,000 )

ABO, 12/31/12

$357,025

Plan assets, 1/1/12

Expected return on assets ($198,200 x 10%)
Actuarial Loss ($198,200 x (6% - 10%))

$198,200
19,820
(7,928)

Contributions
Benefits paid out

44,000
(26,000 )

Plan assets, 12/31/12

$228,092

Accounts reported on the balance sheet:

Accrued benefit obligation
Plan assets at fair value

$(357,025)
228,092

ABO in excess of plan assets (under-funded)

Unamortized past service cost
Unamortized Actuarial Loss
Accrued pension liability (107,050 + 65,8323 - 44,000)

(128,933)
0
0
($128,933)

Pension expense 2011:

Current service cost
Interest on accrued benefit obligation
Actual return on plan assets (8% of $165,000)
Past service cost
Actuarial (Gain)/Loss

$ 35,000
19,250
(13,200)
100,000
0

(d)

$141,050
Pension expense 2012:
Current service cost
Interest on accrued benefit obligation
Actual return on plan assets (6% of $198,200)
Past service cost
Actuarial (Gain)/Loss

$47,250
30,525
(11,892)
0
0
$ 65,833

(e)

The deferral and amortization approach results in a more stable expense number
on the income statement. The deferral and amortization approach expense may
increase each year, yet the expense under the immediate recognition approach is
much more volatile.

(f)

The immediate recognition approach results in a better measure of the pension

plans unfunded liability on the balance sheet in terms of expected future cash
flows at an earlier date.

QUESTION 2 (40 marks)

Mulholland Corp., a lessee, entered into a non-cancellable lease agreement with Galt
Manufacturing Ltd., a lessor, to lease special purpose equipment for a period of seven
years. Both Mulholland and Galt follow private enterprise GAAP. The following
information relates to the agreement:

Lease inception

May 2, 2011

Annual lease payment due at the beginning of each lease year

$?

Residual value of equipment at end of lease term, guaranteed by

an independent third party

$100,000

Economic life of equipment

10 years

Usual selling price of equipment

$415,000

Manufacturing cost of equipment on lessors books

$327,500

Lessors implicit interest rate, known to lessee

12%

Lessees incremental borrowing rate

12%

Executory costs per year to be paid by lessee, estimated

$14,500

The leased equipment reverts to Galt Manufacturing at the end of the lease, although
Mulholland has an option to purchase it at its expected fair value at that time. Galt also
has concluded that the credit risk of Mulholland is normal and there are no
unreimbursable costs associated with this lease.

Instructions:
(a) Using time value of money tables or a financial calculator calculate the lease
payment determined by the lessor to provide a 12% return.
(b) Prepare a lease amortization table for Galt Manufacturing, the lessor, covering the
entire term of the lease.

(c) Assuming that Galt Manufacturing has a December 31 year end, and that
reversing entries are not made, prepare all entries made by the company up to and
including May 2, 2013.
(d) Identify the balances and classification of amounts that Galt Manufacturing will
report on its December 31, 2011 balance sheet, and the amounts on its 2011
income statement and statement of cash flows related to this lease.
(e) Assuming that Mulholland has a December 31 year end, and that reversing entries
are not made, prepare all entries made by the company up to and including May 2,
2013. Assume payments of executory costs of $14,000, $14,400, and $14,950
covering fiscal years 2011, 2012, and 2013, respectively.
(f) Identify the balances and classification of amounts that Mulholland will report on
its December 31, 2011 balance sheet, and the amounts on its 2011 income
statement and statement of cash flows related to this lease.
(g) On whose balance sheet should the equipment appear? On whose balance sheet
does the equipment currently get reported?

Solution:
(a)

For the purpose of calculating the lease payment that will yield a 12% return
to Galt, the residual value guaranteed by a third party will be included in the
calculations below:

Using a financial calculator:

PV
$ (415,000)
I
12%
N
7
PMT
$ ?
FV
$ 100,000
Type
1

Yields $72,341

(b)
Galt Manufacturing Ltd. (Lessor)
Lease Amortization Schedule

Date
5/2/11
5/2/11
5/2/12
5/2/13
5/2/14
5/2/15
5/2/16
5/2/17
5/2/18

Annual
Lease
Payment
Plus RV
$72,341
72,341
72,341
72,341
72,341
72,341
72,341
100,000
$606,387

Interest
(12%) on Net
Investment

$41,119
37,372
33,176
28,476
23,213
17,317
10,714
$191,387

10

Net
Investment
Recovery
$72,341
31,222
34,969
39,165
43,865
49,128
55,024
89,286
$415,000

Balance
of Net
Investment
$415,000
342,659
311,437
276,468
237,303
193,438
144,310
89,286
0

(c)
5/2/11

5/2/11

12/31/11

5/2/12

5/2/12

12/31/12

5/2/13

5/2/13

Lease Payments Receivable*................................. 606,387

Cost of Goods Sold................................................. 327,500
Sales.............................................................
Inventory.....................................................
Unearned Interest Income
Leases.......................................................
* ($72,341 X 7) +$100,000
Cash

..................................................................... 72,341
Lease Payments Receivable.....................

Unearned Interest Income

Leases....................................................... 27,413
Interest Income.........................................
[($415,000 $72,341) X .12 X 8/12]
Unearned Interest Income
Leases....................................................... 13,706
Interest Income.........................................
[($415,000 $72,341) X .12 X 4/12]
Cash

..................................................................... 72,341
Lease Payments Receivable.....................

Unearned Interest Income

Leases....................................................... 24,915
Interest Income.........................................
[($415,000 $72,341 - $31,222) X .12 X 8/12]
Unearned Interest Income
Leases....................................................... 12,457
Interest Income.........................................
[($415,000 $72,341 - $31,222) X .12 X 4/12]
Cash

..................................................................... 72,341
Lease Payments Receivable.....................

11

415,000
327,500
191,387

72,341

27,413

13,706

72,341

24,915

12,457

72,341

(d)
As at and for the period ending December 31, 2011
Balance sheet:
Current assets
Net investment in leases
Noncurrent assets (investments)

$ 72,341
297,731 *

* ($342,659 + $27,413 - $72,341 current)

Statement of income:
Sales
Cost of goods sold
Gross profit
Interest income

$ 415,000
327,500
87,500
27,413

Statement of cash flows:

Operating Activities:
Cash received for lease

$ 72,341

(e) Mulholland Corp. would account for the lease as an operating lease since:
Using a financial calculator:
PV
$ ?
I
12%
N
7
PMT
$ 72,341
FV
$0
Type
1

Yields $369,764

The lease term (7 years) is less than 75% of the economic life (10 years) of the leased
asset. The lease term is 70% (7 10) of the assets economic life. There is no
bargain purchase option and the present value of minimum lease payments of
$72,341 represents 89% ($369,764 / $415,000) of the fair value at May 2, 2011 of
$415,000 falling short of the criteria of 90% to treat the lease as a capital lease.

12

Fiscal year ending December 31, 2011:

During 2011:
Executory Expenses .......................................
Cash..........................................................

5/2/11

12/31/11

5/2/12

12/31/12

72,341

Rent Expense ..................................................

Prepaid Rent.................................................
($72,341 X 8/12)

48,227

72,341

48,227

14,400
14,400

Rent Expense ..................................................

Prepaid Rent.................................................
($72,341 X 4/12)

24,114

Prepaid Rent ...................................................

Cash..........................................................

72,341

Rent Expense ..................................................

Prepaid Rent.................................................
($72,341 X 8/12)

48,227

Fiscal year ending December 31, 2013:

During 2010:
Executory Expenses .......................................
Cash..........................................................

5/2/13

14,000

Prepaid Rent ...................................................

Cash..........................................................

Fiscal year ending December 31, 2012:

During 2012:
Executory Expenses........................................
Cash..........................................................

5/2/12

14,000

Rent Expense...................................................

13

24,114

72,341

48,227

14,950
14,950

24,114

Prepaid Rent.................................................
($72,341 X 4/12)
5/2/13

Prepaid Rent ...................................................

Cash..........................................................

24,114

72,341
72,341

(f)
As at and for the period ending December 31, 2011
Balance sheet:
Current assets:
Prepaid rent
$ 24,114
Statement of Income:
Rent expense
Executory costs

$ 48,227
14,000

Statement of cash flows:

Operating Activities:
Cash paid for lease

$ (72,341)

(g) In this set of circumstances, the equipment is on neither the lessors (Galts)
nor the lessees (Mulhollands) balance sheets. The equipment should likely
be on the balance sheet of the lessor as they have avoided recording the lease
as an operating lease by involving a third party in the guaranteed residual
value. In this case, the present value of minimum lease payments represents
89% of the fair value of the asset. This is very close to the 90% capitalization
criteria guideline. The 90% criteria is not an absolute rule and therefore
accountants should look beyond the numbers to the substance of the
transaction to determine the accounting treatment of the lease; in this case
capitalization of the lease may be a more meaningful presentation.

14

QUESTION 3 (20 marks)

Answer the following questions directly on the examination copy.
3.1 In a defined benefit plan, for the employer, the term funding refers to
a. being responsible for the assets of the pension plan.
b. determining the accumulated benefit obligation.
c. making periodic contributions to a funding agency to ensure that funds are
available to meet retirees' claims.
d. calculating the amount to report for pension expense.
3.2 For a lessee, the minimum lease payments may include
a. the minimum rental payments and a guaranteed residual value only.
b. the minimum rental payments and a bargain purchase option only.
c. a bargain purchase option and a guaranteed residual value.
d. the minimum rental payments and a bargain purchase option or a guaranteed
residual value.
3.3 Which of the following is a correct statement regarding one of the ASPE
capitalization criteria?
a. The lease transfers ownership of the property to the lessor.
b. The lease must contain a bargain purchase option.
c. The lease term is 75% or more of the leased propertys estimated economic
life.
d. The fair value of the minimum lease payments is equal to 90% or more of
the present value of the leased asset.
3.4 Using the deferral and amortization approach, unrecognized net actuarial gains and
losses should be
a. recorded currently as an adjustment to pension expense in the period incurred.
b. recorded currently and in the future by applying the corridor method which
provides the amount to be amortized.
c. amortized over a 15-year period.
d. recorded only if a loss is determined.
3.5 Vested benefits
a. usually require a certain minimum number of years of service.
b. are those that the employee is entitled to receive even if s/he is fired.
c. are not contingent upon additional service under the plan.
d. are defined by all of these.

15

3.6 On July 1, 2012, Nickel Ltd leases equipment from Dime Corp, under an eight year
capital (finance) lease. Equal annual payments of $100,000 are required,
payable on July 1 of each year. The first payment is made on July 1, 2012. The
appropriate rate of interest for this lease is 9%, and title will transfer to Nickel at
the end of the lease contract. The fair value of the equipment is $620,000 and
the cost in Dime's accounting records is $550,000. The present value of the
lease payments is $620,000. What is the amount of gross profit and interest
income that Dime would record for the year ended December 31, 2012?
a. $0 and $23,400.
b. $0 and $36,000.
c. $70,000 and $23,400.
d. $70,637 and $23,400.
c. $620,000 $550,000 = $70,000.
($620,000 $100,000) .09 x 6/12 = $23,400.
3.7 For a sales-type lease (called a manufacturer or dealer lease in IFRS),
a. the sales price includes the present value of the unguaranteed residual value.
b. the present value of the guaranteed residual value is deducted to determine
the cost of goods sold.
c. the gross profit will be the same whether the residual value is guaranteed or
unguaranteed.
d. cost of goods sold is not recognized.
3.8 Daikon Ltd. received the following information from its pension plan trustee
concerning their defined benefit pension plan for the year ended December 31,
2012. The corporation uses the deferral and amortization approach.
Jan 1, 2012
$2,100,000
2,400,000
270,000

Fair value of plan assets

Accrued benefit obligation
Unrecognized past service costs

Dec 31, 2012

$2,250,000
2,580,000
240,000

For 2012, the current service cost is $180,000 and the amortization of the past
service costs is $30,000. The interest rate on the liability is 10% and the expected
rate of return on plan assets is 9%. What is the amount of pension expense for
2012 assuming current service costs, contributions and benefits are at the end of
the year and no actuarial gains or losses are accounted for?
a. $265,500.
b. $261,000.
c. $216,000.
d. $180,000.
b. $180,000 + $30,000 + ($2,400,000 .10) ($2,100,000 .09) = $261,000.

16

3.9 On January 1, 2012, Adams Corp signed a ten-year non-cancellable lease for
machinery. The terms of the lease called for Adams to make annual payments
of $100,000 at the end of each year for ten years with title to pass to Adams at
the end of the lease period. Adams accordingly accounted for this lease
transaction as a capital (finance) lease. The machinery has an estimated useful
life of 15 years and no residual value. Adams uses straight-line depreciation for
all of its property, plant and equipment. The lease payments were determined to
have a present value of $671,008 at an effective interest rate of 8%. It was also
determined that the fair value of the machinery on January 1, 2012 was
$671,008. With respect to this lease, for the year ending December 31, 2012,
Adams should report (rounded to the nearest dollar)
a.
b.
c.
d.

lease expense of $100,000, and depreciation expense of $44,933.

interest expense of $53,681 and depreciation expense of $44,933.
interest expense of $53,681 and depreciation expense of $44,734.
interest expense of $53,920 and depreciation expense of $67,101.

c. $671,008 .08 = $53,681; $671,008 15 = $44,734.

3.10 Presented below is pension information related to Cantaloupe Ltd. for the year 2012.
The corporation uses the immediate recognition approach.
Current service cost
Actual return on plan assets
Interest on accrued benefit obligation
Actuarial experience loss
Past service costs agreed to at Jan 1/12

$900,000
210,000
390,000
90,000
165,000

The pension expense to be reported for 2012 is

a. $1,515,000.
b. $1,395,000.
c. $1,335,000.
d. $1,155,000.
c. $900,000 + $390,000 + $90,000 + $165,000 $210,000 = $1,335,000.

17