Exam 1 - Spring 2006 - Acct 414

Exam 1 – Acct 414 – Spring 2006 Page 6

Name: ______

Exam 1Acct 414 – Corporate Accounting & Reporting II Spring 2006

Show any necessary computations if you want to be eligible for partial credit. Present your work in a neat, well-organized manner. If you are using a PV calculator, spell out what you put in for n, i, PMT, FV, PV, etc. Draw a time-line if that would explain your thinking to me.

Follow the instructions and answer all parts of the question as directed.

1-4. Time Value of Money (15 points each, max = 60)
5-6. Leases. (60 points total)
7-8. Troubled debt (50 points total)
9. Serial Bonds (30 points)
Extra credit points (if any) total: ______
Total points earned (max = 200)

Time Value of Money – problems 1 through 4 (15 points each = 60 points total)

1. Assume that you are working for a leasing company. The boss asks you to compute the annual lease payment that the company should charge to earn a 12% return on the following lease: Fair market value of leased asset $120,000. The first payment will be made immediately. Lease term will be 6 years. The property should be worth $15,000 when it is returned to the lessor.

2. How much should you pay to buy a $10,000 face value semi-annual bond with an 8% per annum stated interest rate if the market rate is currently 12% (compounded semiannually) for bonds with comparable risk? The bonds will mature in 10 years.

3. Troubled debt restructuring: The debtor owes $40,000 plus $4,000 in accrued interest on a note payable. The original interest rate was 10%. The creditor agrees to modify the terms of the agreement such that the debtor will pay interest at an 8% annual rate for 5 years on a reduced principal balance of $25,000. Determine the loss the creditor will recognize on this troubled debt restructuring.
For 5 points extra credit: What is the interest rate that the debtor will use to recognize interest during the life of the restructured note payable? (Could be as low as 0%)

4. Princeton Pudding Inc. is establishing a pension plan for its employees. The actuary determines that $5,078,000 will be needed in pension plan assets 15 years from now. What equal annual deposit to the pension plan should PPI make at the end of each of the next 15 years if the plan assets are expected to earn 10% interest?

5. Lease Accounting – (30 points)

Tobby Co. manufactures machines to be sold or leased. On January 1, 2006, Tobby leased machinery to Upsilon, Inc. for a 5-year period. At the end of the lease term, the machinery is to be returned to Tobby. The machinery should be worth $10,000 at the end of the lease. Equal $21,168.38 payments are due at the beginning of each of the 5 years. Toby has no material uncertainties, and the likelihood of collecting all lease payments is high. The implicit rate of the lease is 7%. Upsilon (the lessee) does not know the implicit interest rate but could borrow money to buy the machinery at 10% per annum. The normal sales price of the machinery is $100,000, and the cost to Tobby is $90,000. The useful life of the machinery is 10 years. You may assume the lease is noncancelable.

a. What type of lease is this for the lessee? Explain. This is an essay question. Use complete sentences (abbreviations okay) and let me know that you know all of the criteria! Give me the “numbers” for the numeric tests! If the lease is a capital lease, tell me the amount that would be capitalized as an asset.

b. What type of lease is this for the lessor? Explain. This is an essay question. Use complete sentences and let me know that you know the all of the criteria! You may refer to part a if you wish.

5. Continued (facts repeated for your convenience)

c. Prepare the journal entries on Tobby’s books (lessor)

January 1, 2006

December 31, 2006

6. Lease Accounting. (20 points)

On April 30, 2006, Muffy Vanderbear, Inc. (lessee) and Leases R Us (lessor) sign a noncancelable lease with the following terms:

1. Term: 5 years / 2. Annual payment = $9,228
3. Implicit interest rate (known to lessee) 8% / 4. Est. fair value of asset at end of lease $15,000
5. Fair value of asset $50,000 / 6. Cost of asset $50,000
7. Incremental borrowing rate: 9% / 8. First payment due immediately
9. Estimated useful life of asset: 7 years / 10. Purchase option at end of lease: $15,000
11. If the purchase option is not exercised, the lessee guarantees that the leased asset will be worth at least $10,000 at lease end. / 12. The lease payments appear to be collectible and there are no additional costs expected by the lessor.
13. Both lessor and lessee use the straight-line depreciation method (no salvage value)

a. What type of lease is this for Muffy Vanderbear, the lessee? Explain briefly. (4 points)

b. Regardless of your answer to part (a), assume this is a capital lease for the lessee. Prepare a lease amortization schedule for Muffy Vanderbear Inc. for the first two years. (9 points)

Date / Lease Payment / Interest Expense / Amortized Principal / Balance

c. Regardless of your answer to a, assume the lease is a capital lease for the lessee. Prepare all necessary journal entries for the lessee, Muffy Vanderbear. Inc. at 4/30/06, 12/31/06 and 4/30/07. (12 points)

4/30/06

12/31/06

Problem 6, part c – continued – facts repeated for your convenience:

On April 30, 2006, Muffy Vanderbear, Inc. (lessee) and Leases R Us (lessor) sign a noncancelable lease with the following terms:

4/30/07

d. If Leases R Us incurred $1,000 in initial direct costs related to the lease terms as originally described and the lease were classified as a direct financing lease, what interest rate would be used to record interest revenue by the lessor? (5 points)

f. EXTRA CREDIT (5 points) MATCHING: For each term, select the best phrase or description from the answers listed below. An answer may be used once, more than once, or not at all.

_____1. Nonrenewal penalty / _____4. Incremental borrowing rate
_____2. Lease term / _____5. Executory costs
_____3. Gross investment in lease

CHOICES:

A. The rate used by the lessee to determine the present value of the minimum lease payments if the lessee's incremental borrowing rate is greater than the lessor's implicit interest rate (known to lessee). Implicit interest rate

B. The costs of ownership which are excluded from the minimum lease payments if paid by the lessor. executory costs

C. Always included in both the lessee’s and the lessor’s minimum lease payments. BPO

D. Included in the lessor's gross investment if there is no title transfer or bargain purchase option. Residual value

E. The rate used by the lessee to determine the present value of the minimum lease payments if the lessee's incremental borrowing rate is less than the lessor's implicit interest rate (known to lesee). Incremental borrowing rate

F. Is not included in the minimum lease payments if it is large enough to assure that the lease will be renewed. Non-renewal penalty

G. Includes any periods covered by bargain renewal options. Lease term

I. Amount recorded as sales revenue when the cost of the leased asset is less than its fair value. Present value of minimum lease payments

J. Minimum lease payments plus any unguaranteed residual value. Gross investment in lease

K. The difference between the fair value of the leased asset and the total payments to be received over the lease term. Unearned interest

7. Troubled Debt (20 points).
Brye Co. is indebted to Dole under a $900,000, 12%, three-year note dated December 31, 2004. Because of Brye's financial difficulties developing in 2006, Brye owed accrued interest of $108,000 on the note at December 31, 2005. Under a troubled debt restructuring, on December 31, 2005, Dole agreed to settle the note and accrued interest for a tract of land having a fair value of $600,000. Brye's acquisition cost of the land is $640,000.

Prepare the creditor’s journal entries at 12/31/05 to record the troubled debt restructuring.

8. Troubled Debt. (30 points)
On Nov. 1, 2005, a $500,000 note to Montana Bank & Trust came due but Blue Bikes Corporation does not have enough cash to make the payment. Blue Bikes has already recorded as interest expense the $45,000 unpaid accrued interest and the bank has, likewise, booked the interest revenue receivable. The original note specified annual payments of $125,000 per year plus 9% interest on the unpaid balance. Since Blue Bikes is unable to make the payments, the bank has agreed to restructure the terms of the loan as follows:

Ø The interest currently due is forgiven and will not need to be paid.

Ø The term of the loan is extended until November 1, 2009.

Ø The interest rate is reduced from 9% to 6% and will be paid annually on the 1st of November.

Ø The principal amount owed is reduced by $30,000 to $470,000.

Ø At the end of four years, on November 1, 2009, the principal will be due in a balloon payment.

Prepare any journal entry (entries) needed on the debtor’s books at Nov. 1, 2005, December 31, 2005, Nov. 1, 2006.

9. Serial Bonds (30 points). On Nov. 1, 2005, Trains R Us Corporation issued $6,000,000 in serial bonds. The bond principal will be repaid in $2,000,000 increments beginning on Nov. 1, 2006 with the final payment to be made on Nov. 1, 2008. The bonds pay interest semi-annually on Nov. 1 and May 1. The coupon rate is 9% per annum. An investment banker handled the transaction and the company has just received a check for $5,895,189. The fiscal year of Trains R Us ends on December 31.

You may choose either the bonds outstanding method or the effective interest method of amortizing bond premiums. Check the appropriate box so I’ll know what you are attempting! Prepare all necessary journal entries on the dates listed.

ð I’m using the bonds outstanding method for a maximum of 30 points

ð I’m using the effective interest method for a maximum of 28 points. If you choose this option, you may assume that the interest rate per year is 10% per annum compounded semi-annually.

December 31, 2005 (NOT the date of issue)

May 1, 2006

November 1, 2006

Acct 414 Exam 1 – Spring 2006 SOLUTION Page 5

5. Lease accounting

a. This is an operating lease for the lessee because it fails all 4 tests. There is no title transfer and no bargain purchase option. The lease term is only 50% of economic life. The lessee uses 10% incremental borrowing rate because he doesn’t know the lessor’s implicit interest rate and the PVMLP = $88,268 which is less than 90% of the FMV of $100,000. [Computation: $21,168.38 * 3.79079 * 1.1 = $88,269]

b. Sales Type lease. Of the first 4 criteria, this lease meets only the last one because it uses its implicit interest rate of 7% which gives a PVMLP = 92,870. (See discussion in (a). Computation: PVMLP = 21,168 * 4.1002 * 1.07 = 92,869 which is greater than 90% of FMV. In addition, there are no collection or other costs uncertainties. It is a sales-type lease rather than a direct financing lease because there is a profit on the transaction (FV > cost).

c. JE at inception of lease and at end of first year of lease – lessee’s books. (amortization table was not required

Problem 6 - lease

a. Capital lease for lessee even though there is no title transfer, no bargain purchase option and the LT is only 71.4% of economic life. The lessee uses the lessor’s implicit rate of 8% and determines that the PVMLP = $46,597 which is within 10% of the $50,000 FMV. Note that there is a GUARANTEED residual value which is part of the minimum lease payments for both lessor and lessee – see amortization table.