AFM 291 Intermediate Accounting - Fall 2019 Midterm#2 Solution Final with Marker Comments - Universi

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AFM 291 Fall 2019 Midterm #2 SOLUTION PAPER (with marks) Instructions: 1. This question paper contains 8 pages including this title page. PV tables are on page 8. Please ensure that it is complete. All responses should be made on the RESPONSE PAPER. This

QUESTION PAPER will not be marked.

2. You may not consult any other materials for any reason. Only non-programmable, non-communicating calculators may be used. You may not listen to or use any communicating or receiving hardware such as a cellular telephone, a Blackberry, or an iPod. 3. If you have a question please ask one of the examination proctors. It is unacceptable for you to communicate with another student for any reason.

4. When you leave the examination, you should hand in the RESPONSE PAPER in which you have answered the examination questions.

Q#

Points Available

1

43

2

27

Total

70 60

Points Awarded

The midterm mark will be calculated using a denominator of 60 (see note at end of Packaging Equipment question) No ½ marks provided (i.e. no 0.5 marks for situations where 1 mark has been allocated) Crowdmark questions (green box on the top left side of the page) maximum marks (72 – includes 2 potential bonus marks for Q4): Question #1 (Whirlpools) 11 marks Question #2 (Fitness Clubs) 10 marks Question #3 (Lounge Chairs) 6 marks Question #4 (Packaging Equipment) 18 marks Question #5 (FR Co-op #1) 7 marks Question #6 (FR Co-op #2) 12 marks Question #7 (Financial Analyst Co-op) 8 marks

Question #1 (43 marks) Spa Equipment Limited (SEL) sells sauna kits, whirlpools and lounge chairs to spas (and recently to gyms and fitness clubs) located across Canada. SEL trades on the TSX and has a September 30th year-end. SEL went public in 2016 and the share price has been rising steadily.

The top stock analysts from the Health Care sector have been promoting investment in SEL. An interest rate of 5% would reflect an appropriate credit risk associated with any debt that SEL undertakes. SEL has a long-term bank loan of $2,900,000 at an annual rate of 5% outstanding throughout the September 30, 2019, fiscal year. All sales are on credit and the company uses a periodic inventory system.

There are 3 standard sizes of Sauna kits. The kit consists of pre-cut cedar wood, a heating unit and a door. The wood is cut and finished and the door is constructed at the plant. The wood, door and heating unit are then packaged and stored in the finished goods warehouse awaiting shipment. When an order is received, the package is shipped and assembled on site at the customer’s location.

You are a member of the audit team working on the September 30, 2019, year-end. The year-end inventory count has taken place; however, the journal entry to allocate Goods Available for Sale to closing inventory and cost of goods sold has not been recorded. The closing entries have not yet been recorded.

Whirlpools: SEL has been purchasing completed whirlpools from a company in Ontario for resale to SEL’s customers. A manufacturer of whirlpools from British Columbia approached SEL and offered deferred payment terms on an order of whirlpools, in order to encourage SEL to purchase from them. On October 1, 2018 SEL took delivery of a shipment of whirlpools from the B.C. company and, in addition to a cash deposit of $30,000, a non-interest bearing note was signed. The note payment terms require $20,000 to be paid on each of October 1, 2019 and 2020. All of these whirlpools were sold during 2019.

Fitness Clubs: As part of your audit procedures, you had a conversation with the Comptroller regarding the 2019 closing Accounts Receivable (A/R) balance. Your notes from this meeting include the following:  Payment terms are net 30 days and payments are normally received within 90 days.  During the 2019 fiscal year, $60,000 of the amounts owing from two spa clientele have been determined to be uncollectible.  During the 2019 fiscal year SEL expanded their market to gyms and fitness clubs located across Canada.  The expansion to the gym and fitness club market has resulted in sales to a couple of fitness clubs that have balances owing at the end of 2019 that are in excess of 90 days overdue. One fitness club has filed for bankruptcy and the amount owing is $52,000.  The balance in the Allowance for Doubtful Accounts at October 1, 2018, was $83,000. The aging of the year-end A/R balances for the spa clientele results in a recommended September 30, 2019 Allowance for Doubtful Accounts balance of $97,000.  An aging of the year-end A/R balances for the gym and fitness club clientele results in an additional September 30, 2019 Allowance for Doubtful Accounts of $210,000 (including the $52,000 owing from the company that filed for bankruptcy).

Lounge Chairs: The lounge chairs that SEL has sold for many years are made of plastic materials. The spa market has been converting to wood constructed furniture and fixtures. In order to remain competitive in this market, SEL is currently converting to Canadian suppliers of wood constructed lounge chairs. SEL determined that plastic lounge chairs costing $595,000 are included in 2019 ending inventory. Normally the gross margin on the lounge chairs is 15%. SEL has determined that, they will need to reduce the regular selling price by 20%, in order to sell these lounge chairs during the 2020 fiscal year.

Packaging Equipment: During the year SEL purchased equipment that packages all of the sauna kit components so that they will be protected during shipment. The equipment was received, installed, and tested on October 1, 2018. The training to use the equipment took place during October and SEL started using the packaging equipment on November 1, 2018. A short-term loan of $975,000 was used to finance the purchase price of the equipment. The loan was taken out on October 1, 2018, and has an annual interest rate of 5%. The loan will be repaid with interest on October 1, 2019. The supplier of the equipment provided the installation, testing and training. The supplier was paid for the equipment, installation and testing on October 1, 2018 and the training was paid for on November 1, 2018.

The equipment is expected to have a useful life of 8 years and a residual value of $20,000. The economic benefits of the equipment are expected to be utilized evenly over the 8 years. SEL applies the number of months of use to determine depreciation.

As part of your year-end audit procedures, you reviewed the amount capitalized for the equipment related purchases. The equipment account balance at September 30, 2019, is $1,066,750 and includes the following:  $975,000 purchase price  20,000 installation cost  15,000 cost of staff operational training  8,000 cost of testing to ensure that the equipment is in working order  48,750 interest expense

Required: As part of the audit documentation records, your audit partner would like you to prepare all of the entries for the 2019 fiscal year-end that should have been recorded for the above scenarios.

You do not need to provide any closing entries; however, you should include any journal entries necessary to allocate Goods Available for Sale to closing inventory and cost of goods sold. Once you have presented your recommended entries, another audit staff member will review the client entries to determine if any correcting entries are required.

You should also provide brief point form comments that provide the financial reporting basis for your recommended entries. Assume all amounts are material to the financial statements.

Respond in the appropriate space provided on the RESPONSE PAPER (i.e. under the headings Whirlpools, Fitness Clubs, Lounge Chairs, and Packaging Equipment.)

Note: Consider the Problem-Solving Process for AFM 291, to help you complete the required.

(Note: dates are not required as part of any journal entry responses) Solution (43) + 2 bonus: Whirlpools: (11) October 1, 2018: DR Whirlpool Purchases CR Cash CR Note Payable

67,188

$30,000 + (20,000/1.05) + (20,000/1.05^2) = $67,188.21 PV if tables used: i = .05 n = 2 $20,000 * 1.859 = $37,180 $30,000 + 37,180 = $67,180 September 30, 2019: DR Interest Expense CR Note Payable $37,188.21 * .05 (1 mark for calculation) DR Cost of Goods Sold CR Whirlpool Purchases

(1) 30,000 (1) 37,188 (1) (2 marks for calculation)

1,859

(1) 1,859 (1)

67,188

(1) 67,188 (1)

Comments:  Financing element due to deferred payment terms – should recognize interest expense separate from cost of goods sold (1 marks for the explanation) Whirlpools marker comments regarding reasons for missed marks:       

No PV calculations or calculated incorrectly Calculated interest on the $2,900,000 bank loan and incorporated it in the solution Confusion regarding the concept of a non-interest bearing note No cost of goods sold entry and/or no interest expense entry Applied a December 31st year-end rather than the September 30th year-end Treated transaction as a sale versus a purchase No comment included to justify recommendations

Wide dispersion of results - significant number of students >= 80% – median of 55%

Fitness Clubs: (10) During the 2019 fiscal year: DR Expected Loss Allowance/Allowance for Doubtful Accounts CR Accounts Receivable ($60,000 + 52,000) (1 mark for calculation)

112,000 112,000

(1) (1)

September 30, 2019: DR Bad Debt Expense 284,000 (1) CR Expected Loss Allowance/Allowance for Doubtful Accounts 284,000 (1) ($97,000 + 210,000) – (83,000 - 60,000) = 284,000 (4 marks for calculation) /or/ ($97,000 + 158,000) – (83,000 – 52,000 – 60,000) = 284,000 Comments:  Accounts Receivable are Financial Assets and Expected Losses/Allowance for Doubtful Accounts should be set up for estimates of future cash flows that may not be received.

(1 mark for the explanation) Fitness Clubs marker comments regarding reasons for missed marks:    

Error in the application of the $52,000 included in the $210,000 when determining the amount of the bad debt expense Entries reversed e.g. DR Allowance and CR Bad Debt expense Write-off entries recorded as a DR Bad Debt expense and CR Allowance No comment included to justify recommendations or comment(s) were included but did not explain the basis for the recommended entries

Well done - significant number of students >= 80% – median of 80%

Lounge Chairs: (6) September 30, 2019: DR Cost of Goods Sold/Loss on Inventory Obsolescence 35,000 (1) CR Finished Goods Inventory/Allowance for Obsolescence 35,000 (1) ($595,000/.85 = $700,000 selling price) (3 marks for calculation) ($700,000 * .80 = $560,000 NRV) ($595,000 – 560,000 = $35,000) Note to marker: If response uses COGS then there should also be a comment that a note to the financial statements is required to disclose the amount of the inventory write-down.

Comments:  Inventory should be recorded at LCNRV – or comment related to future cash flows/economic benefits of the asset below cost (1 mark for the explanation) Lounge Chairs marker comments regarding reasons for missed marks:   

Errors in applying a gross margin % to cost in order to determine the selling price before discount e.g. multiplied cost by 1.15 rather than dividing by .85 Determined that the selling price was below cost; however did not recommend a write-down to LCNRV Used the $700,000 selling price to determine the write-down

Generally very well done or done poorly - significant number of students >= 80% and many = 100% – median of 67%

Packaging Equipment: (16) October 1, 2018: DR Cash CR S.T. Loan

975,000 975,000

October 1, 2018: DR Equipment CR Cash $975,000 + 20,000 + 8,000 = $1,003,000

1,003,000 (1) 1,003,000 (1) (2 marks for calculation)

November 1, 2018: DR Training Expense CR Cash September 30, 2019: DR Interest Expense CR Interest Payable DR Depreciation Expense CR Accumulated Depreciation ($1,003,000 – 20,000)/8 * 11/12

15,000 15,000

48,750 48,750 112,635.42 112,635.42 (2 marks for calculation)

(1) (1)

(1) (1)

(1) (1) (1) (1)

Comments: (2 marks for the explanation and can be based on any 2 of the first 3 points below – 1 bonus if comment on all of the first 3 points and additional bonus mark for potential earnings management related comment)  Training should not be capitalized - PP&E standard excludes training – staff could leave next day – do not capitalize human capital costs etc.  Installation and testing are expenditures necessary to ensure equipment is in a condition for use and therefore should be capitalized  Asset is not a qualifying asset for interest capitalization – received, installed and tested on the first day of the year  Any concern regarding earnings management – analysts have recommended the company’s stock and management has chosen to capitalize interest and training costs Packaging Equipment marker comments regarding reasons for missed marks:  Many students prepared correcting entries when the required asked for entries that should have been prepared (and there was insufficient detail from the correcting entries to determine the “entry that should have been done”)  Calculated a weighted average expenditure and applied an interest rate to determine an interest capitalization amount  Capitalized training expense  Expensed installation and testing  Minimal comment(s) included to justify recommendations  Confusion regarding the year-end and the timing of interest and principal payments on the loan



Interpreted the question required as “prepare only the recommended 2019 year-end ADJUSTING entries” i.e. only depreciation and interest expense entries provided

Median of 39% Adjustment to denominator when calculating midterm mark: The markers observed evidence of misinterpretation of the requirements for this question (i.e., many students only provided year-end adjusting entries).The midterm denominator will be reduced by 10 marks (i.e., the grade for the exam will be calculated using a denominator of 60 marks rather than 70 marks). This adjustment was chosen because there are 8 marks for the first 3 journal entries in the solution and 2 marks for the explanation related to these journal entries.

Question #2 (27 marks) Let It Shine Inc. (LIS Inc.) is a Canadian manufacturer of solar panels. The company is publicly traded, has an April 30th year-end, and uses a periodic inventory system and FIFO costing. You are a co-op student working for LIS Inc. For the first two months of your work term, you worked in the financial reporting department and for the final two months of your work term you worked as a financial analyst in the corporate finance department.

Financial Reporting Co-op Assignment #1: Your first co-op assignment in the financial reporting department was to comment on the accounting treatment of the 2019 fiscal year-end transactions related to the construction of a manufacturing facility. LIS Inc. commenced operations in Ontario during 2015. The company has experienced significant growth over the last several years. During November 2017, LIS Inc. hired Ball Construction Limited to build a Quebec manufacturing facility. The plant will supply solar panels for sales to the Quebec and Eastern Canada market. The 2018 year-end payments to Ball Construction Limited were minimal and were financed using available cash. On May 1, 2018 LIS Inc. borrowed $10,000,000 at an annual interest rate of 5% to finance part of the additional facility construction costs. These funds have been set aside to be used only for the manufacturing facility construction costs. Excess cash was used to finance the balance of the construction costs during the 2018-19 fiscal year. The principal and interest from the borrowing are due on May 1, 2019.

The following payments were made to Ball Construction Limited during the 2018-19 fiscal year: $8,000,000 on July 1, 2018 and $7,000,000 on November 1, 2018. No temporary investment income was earned on the available financing. The facility was completed April 30, 2019.

The following 2019 year-end journal entries were recorded: May 1, 2018: DR Cash CR Short-term Loan

$10,000,000 10,000,000

July 1, 2018: DR Manufacturing Facility CR Cash

$8,000,000 8,000,000

November 1, 2018: DR Manufacturing Facility CR Cash

$7,000,000 7,000,000

Financial Reporting Co-op Assignment #2: Your second co-op assignment in the financial reporting department was to review the 2019 year-end inventory entries to determine if any additional entries are required. The inventory count took place on April 30th and the entry to allocate Goods Available for Sale to closing inventory and cost of goods sold has been completed.

You were informed that as part of the internal audit cut-off procedures, it was determined that a shipment of steel used in manufacturing the solar panels was in-transit from Hamilton to LIS Inc. and was excluded from the year-end inventory count. The shipment was FOB shipping point.

The cost of the steel is $982,000 and the shipping invoice is $980. Neither of these invoices have been recorded. It has been determined, that other than potential issues related to this in-transit shipment, the closing inventory count and costing of the year-end inventory is correct.

The internal audit team also determined that a purchase of $889,000 of steel with associated shipping costs of $890 was in transit on April 30, 2018. This steel was shipped FOB shipping point. The following entry was recorded in the 2018-2019 accounts during May 2018 regarding this purchase: DR Purchases Steel DR Freight Expense CR Cash

889,000 890 889,890

Financial Analyst Co-op Assignment: During your two months with the corporate finance department, one of your assignments required you to determine certain cash amounts related to company investments. You were provided with the following information for some investment holdings and asked to provide the cash amount of interest and dividends received during the year.

April 30, 2019 April 30, 2018 Statement of Financial Position Information: Amortized Cost Corporate Bond $1,027,751 $1,036,299 FVOCI Corporate Bond 5,743,533 0 Investment in Associate 6,833,000 6,700,000 Equity FVPL 1,203,000 986,000

Statement of Comprehensive Income Information: Interest Revenue (Amortized Cost Bond) Interest Revenue (FVOCI Corporate Bond) Investment Income (Investment in Associate) Dividends (Equity FVPL)

2019 $41,452 232,444 $175,000 $28,000

The Amortized Cost bonds have a face value of $1,000,000, 5 year life, were purchased on May 1, 2017 for $1,044,518, and have an effective interest rate of 4%. The FVOCI Corporate Bonds have a face value of $5,000,000, 10 year life, were purchased on May 1, 2018 for $5,811,089, and have an effective coupon rate of 4%. The Investment in Associate represents a 30% investment in Sun Electric Inc., LIS Inc.’s supplier of electrical parts. The FVPL shares were purchased during November 2017.

Required: In the space provided on the RESPONSE PAPER,  Comment on the current accounting treatment for the Quebec manufacturing facility.

Provide any recommended correcting entries and include brief point form comments to support your recommendations.  Comment on the current accounting treatment for the 2018 and 2019 in-transit shipments of steel. Provide any recommended correcting entries for both the 2018 and 2019 fiscal yearends and include brief point form comments to support your recommendations.  Determine the amount of cash received as interest on the bonds and cash received for dividends on the equity during the 2019 year-end, for the investments noted above. You are required to show your work, so that your supervisor can check the determination of the cash amounts.

Respond in the appropriate space provided on the RESPONSE PAPER (i.e. under the headings Financial Reporting Co-op Assignment #1, Financial Reporting Co-op Assignment #2 and Financial Analyst Co-op Assignment.) Assume all amounts are material to the financial statements.

Note: Consider the Problem-Solving Process for AFM 291, to help you complete the required.

Solution (27): Financial Reporting #1: (7) Weighted Average Expenditure Base: $8,000,000 * 10/12 7,000,000 * 6/12 Total Capitalized Interest on Specific Debt: $10,000,000 * .05 =

$6,666,666 3,500,000 10,166,666

$500,000

(1) (1)

(1)

Additional entry required: DR Manufacturing Facility CR Interest Payable

500,000 500,000

(1) (1)

Comments: (2 marks for the explanation)  Qualifying Asset – requires a substantial period of time to get ready for use – interest should be capitalization as part of the cost of the warehouse.  The weighted average expenditure base is greater than the asset specific borrowing. We can only capitalize interest costs to the extent of interest expense incurred.

Financial Reporting Co-op #1 marker comments regarding reasons for missed marks:      

Did not calculate the weighted average expenditure base Repeated the entries already provided in the question although the question asked for correcting entries – no marks deducted for this; however time lost by doing this Used CIP account names rather than the account name provided in the problem Capitalized interest in excess of actual interest costs for the year i.e. based on the WAEB of $10,166,666 – capitalized $508,333 when there is only $500,000 of interest expense Credit to interest expense versus interest payable No comment included to justify recommendations

Wide distribution of results - many students >= 80% – median of 43%

Financial Reporting #2: (12) Shipment in transit on April 30th, 2019 DR Raw Material Steel Inventory CR Accounts Payable

982,980 982,980

(1) (1)

Comments: (2 marks for the explanation)  Goods are FOB shipping point and therefore controlled by LIS Inc.  Shipping costs are necessary to get inventory to LIS Inc. location and therefore should be capitalized as part of inventory.

Shipment in transit on April 30th, 2018 Entry for 2018 Year-end: DR Raw Material Steel Inventory CR Accounts Payable

889,890 889,890

(1) (1)

889,890 889,890

(1) (1)

890

(1) (1)

Entry for 2019 Year-end: DR Accounts Payable CR Raw Material Steel Inventory DR Cost of Goods Sold CR Freight Expense

890

Comments: (2 marks for the explanation)  $889,890 should have been recorded as part of 2018 year-end inventory and included in Accounts Payable  The April 30, 2019 year-end inventory is correct (after the above recommended entry)  COGS for the 2019 year-end already has the $889,000 included (it should have been in opening inventory but it was part of Purchases)  The freight-in is part of the inventory cost and therefore part of COGS Financial Reporting Co-op #2 marker comments regarding reasons for missed marks:    

Entries used Cash rather than Accounts Payable Did not capitalize incoming freight as part of the cost of inventory Did not make any corrections for 2018 /or/ applied corrections to Retained Earnings (even though the 2018 impact was only to year-end inventory and not Cost of Goods Sold) Used the Purchase account rather than the Inventory account

Poorly done – median of 21%

Investments: (8) 2019 cash interest and dividends Amortized Cost Bond: Interest Revenue: Premium Amortization: Cash

$41,452 8,548 $50,000

(1) (1)

There is an error in the question description of the FVOCI bond. The description should have stated “an effective interest rate of 4%” instead of the current description of “an effective coupon rate of 4%”. Given this error, two solutions were accepted Solution #1 FVOCI Cash Interest: Cash Interest Revenue - $5,000,000 * .04 = $200,000 (2) Solution #2 FVOCI Cash Interest: Interest Revenue: Premium Amortization: Cash

$232,444 67,556 $300,000

(1) (1)

$6,700,000 175,000 (6,833,000) $42,000

(1) (1) (1)

Investment in Associate: Opening balance Investment Income Closing balance Cash dividends received Equity FVPL: Dividends received are recorded in net income: $28,000 cash received

(1)

Financial Analyst Co-op marker comments regarding reasons for missed marks:  Solutions included calculations for the PV of the bonds and the purchase journal entries for the bonds – determined the cash for the purchase and not the cash for the interest  Provided journal entries for year-end fair value adjustments  Errors in determining the amount of the amortization of the premiums  Used the 30% investment income for the Investment in Associate as the cash amount  Deducted the premium amortization from the interest revenue rather than adding it to determine cash amount Generally very well done or poorly done - significant number of students >= 80% and significant number = 100% – median of 50%