Financial Accounting Theory (ACTG 350)

EXAM II

WINTER 1998

NAME SOLUTION

I. ALTERNATIVE REVENUE RECOGNITION METHODS (10 points and minutes)

Chernobyl Construction Company entered into a contract to construct a small power plant for a fee of $50 million dollars. Construction began in 1995 and was completed in 1997. Transactions related to the contract are summarized below:

1995

1996

1997
Cost incurred during the year $ 8.0 million $16.6 million $15.9 million
Estimated costs to complete $32.0 million $16.4 million $ -0-
Billings and collections during the year $ 7.5 million $20.0 million $22.5 million

Compute the income that should be recognized each year using:

    1. the percentage-of-completion method
    2. the completed contract method
 

1995

1996

1997
a. Income- % completion method $ 2 million $ 3.4 million $ 4.1 million
b. Income- completed contract method $ 0 $ 0 $ 9.5 million

a. 8/40 = 0.20. 20% x ($50 - $40) = $2.0 million

    24.6/41 = 0.60. 60% x ($50 - $41) = $5.4 million. $5.4 – $2.0 = $3.4 million

    $50 - $40.5 = $9.5 - $2.0 - $3.4 = $4.1 million

 b. $50- $40.5 = $9.5 million

 II. RETURN ON ASSETS AND RETURN ON COMMON EQUITY (12 points and minutes)

 

Firm 1

Firm 2

Firm 3
Total assets

$ 500

$ 500

$ 500
Total liabilities

$ 250

$ 350

$ 300
Total shareholders equity

$ 250

$ 150

$ 200
Interest rate

12.0%

8.0%

?
Sales

$ 700

$ 700

$ 700
Net income before interest and taxes

50

?

$ 75
Interest expense

30

?

?
Taxable income

20

?

?
Provision for taxes (30%)

6

?

?
Net income

$ 14

?

?

Required:
  1. For Firm 1, compute the return on assets (ROA) and the return on common shareholders’ equity (ROCE) for the first year of operations. Disaggregate ROA into profit margin and asset turnover. Disaggregate ROCE into ROA, capital structure leverage and common earnings leverage. Explain specifically why ROA and ROCE differ. Use the dollar and percentage interest costs in your explanation.

    2. ROA = PM x ATO = NI + Int. (1-T) x Sales = 14 + 30(.7) x 700 = 0.05 x 1.4 = 0.070 = 7%

                                         Sales               Avg TA        700          500

     

    ROCE = ROA x CSL x CEL = ROA x Avg TA x       NI                =   500 x   14            = .07 x 2 x .4 = 5.6%

                                                                   Avg SE          NI + Int. (1-T)   250     14 + 30(.7)

     ROCE is less than ROA because the earnings on borrowed funds is 7% after taxes while the after-tax cost of borrowing is 8.4%. This means that owners must make up the difference and hence, their return is lower.

    Earnings on borrowed funds are 7% x $250 = $17.50 (7.0%)

    Cost of borrowing is (12% x 0.70) x $250 =     $21.00 (8.4%)

    Net cost of borrowing                                       $ 4.50 (1.4%)

     b.   For Firm 2, calculate the net income at which the ROA and ROCE would be equal.

    ROA = ROCE = NI + 28(.7) = NI .

                                 500               150

     Solving for NI gives NI = $8.4 and both ROA and ROCE = 5.6%

    c. OPTIONAL BONUS QUESTION: For Firm 3, what is the maximum interest rate that could be paid on the borrowing without owners being made worse off than if they had not borrowed? (Hint: at this interest rate, ROA equals the after tax cost of borrowing.)

NI = (75-300r)(.7) = 52.5 – 201r

 ROA = NI + (300r)(.7) = 0.7r = 52.5 = .105 = 0.7r. r = .105/0.7 = 15%

        500                            500

III.  ESTIMATING BAD DEBTS (10 points and minutes)

At the end of 1997 but before the adjusting entries were recorded the records of a company showed the following:

Accounts receivable – trade $ 90,000

Allowance for doubtful accounts (credit) $ 2,500

Bad debt to be written off before adjusting entries $ 3,000

Sales revenue (30% are credit sales) $300,000

 

Required: Compute the following amounts and show computations.

 

Financial Statements at the

End of 1997

Case A:

Bad debts estimated as

2% of credit sales

Case B:

Bad debts estimated as 3% of accounts receivable
Income Statement

    Bad debt expense

      $ 1,800      $ 3,110
Balance Sheet

    Accounts receivable

    $ 87,000    $ 87,000
Balance Sheet

    Allowance for doubtful accounts

     $ 1,300     $ 2,610

 Allowance for bad debts

a.   $2,500 - $3,000 + $1,800 = $1,300

b.  $2,500 - $3,000 + Bad debt expense = $2,610

IV. INVENTORY COST FLOWS (15 points and minutes)

     

    Date Transactions Units Unit Cost
    January 1 Beginning Inventory 4,000

    $1.30
    January 7 Purchase #1 6,000

    $1.10
    January 17 Sale (@$4.00) 7,000  
    January 26 Purchase #2 2,000

    $1.00

     Required:

    a. Based on the inventory transactions above compute the ending inventory and cost of goods sold for the following inventory cost flow assumptions:

     

    Inventory Cost Flow Method

    Ending Inventory

    Cost of Goods Sold

    FIFO

    $ 5,300

    $8,500

    Weighted average

    $ 5,750

    $8,050

    LIFO – periodic

    $ 6,300

    $7,500

    LIFO - perpetual

    $ 5,900

    $7,900

     

    b. What is LIFO liquidation, and what are the potential costs to the firm?

    A LIFO liquidation occurs when a layer of inventory costs added in a previous year is assumed to be sold (matched with revenue) in the current period. This can only occur when sales exceed purchases (production). LIFO liquidations may occur voluntarily (discontinue product) or involuntarily (strike). One cost is higher tax liability if prices have risen since LIFO was adopted. The expected tax advantage of LIFO turns into a disadvantage because older, lower costs (LIFO layers) are matched with current revenues. Another cost may be lost sales.

    V. NOTES RECEIVABLE (8 points and minutes)

On January 2, 1994 a company accepted a three year, $50,000 note from a customer for goods. The amortization table appears below:
 

Date

 Cash received Interest revenue  

Amortization

  

Book Value
Jan. 2, 1994      

$ 52,621
July 1, 1994

$ 2,500

$ 2,105

$ 395

$ 52,226
Jan. 2, 1995

$ 2,500

$ 2,089

$ 411

$ 51,815
July 1, 1995

$ 2,500

$ 2,073

$ 427

$ 51,388
Jan. 2, 1996

$ 2,500

$ 2,056

$ 445

$ 50,943
July 1, 1996

$ 2,500

$ 2,038

$ 462

$ 50,481
Jan. 2, 1997

$52,500

$ 2,019

$ 481

$ -0-

 Required:

2. The coupon rate (state interest rate) on the note was 10% .

3. The implied market rate of interest reflected in the interest calculations is 8% .

4. Show the journal entry on July 1, 1995 to record the receipt of interest and revenue recognition.

CASH                                                  2,500

          PREMIUM ON NOTES REC.             427

         INTEREST REVENUE                     2,073

VI. GROSS MARGIN METHOD (6 points and minutes)

A company prices merchandise to yield a gross margin of 25% of selling price. The inventory on August 1 was $30,000 and sales and purchases in August and September are given below. Compute reasonable estimates of ending inventory for each month. Show computations.
Month Sales Purchases Ending Inventory
August $160,000 $126,000 $ 36,000
September $180,000 $128,000 $ 29,000