B301 Company Accounting
Suggested solution to Specimen Examination (October 2000) – For re-sit student
Question 1 (10 marks)
(a) A property held for own use is a fixed asset of the business. As the property is used to generate income on a continuing basis, it is necessary to charge a portion of the cost of the assets against income each year in respect of the use of the property over its useful life. Land held for own use is not depreciable because land has unlimited life. If the buildings are recorded in the balance sheet at a revalued amount, the revalued amount should be used in the calculation instead of historical cost.
(b) A property which is held for its investment potential is not used to generate income as part of the trading operations of the business and so no depreciation charge is required. For investment property, the important issue is the current value of the properties and the changes in their current value, rather than a calculation of systematic annual depreciation.
(c) For land and buildings in the course of development ore redevelopment, they should be regarded as trading stocks of an enterprise and should be accounted for as such.
(d) For land and buildings held for production, rental or administrative purposes or where no decision has yet been taken to resell the land and buildings, they should be included in the account as assets and be depreciated.
Question 2 (10 marks)
(a) A hedge refers to the arrangement made to protect a contracting party against foreign currency losses. This is accomplished by creating an offsetting balance in the same foreign currency. Most companies hedge their monetary liabilities in foreign currency denominations. For example, if a Hong Kong company has to repay an outstanding loan obtained from Japan, it may enter into a forward exchange contract with a bank or a financing company for the amount in Hong Kong dollars. Then the loan amount will be exchange for Japanese yen at a specified rate at a specified time in the future.
(b) Temporal method regards foreign currency translation as a measurement conversion process that only changes the unit of measurement not the attribute of the item being measured. Therefore under this method items are translated according to their basis of valuation. That is to say items measured at historical cost are translated at the historical rate; items measured at current basis are translated at the current rate. A shortcoming of the temporal method is that the process of translation changes the relationship between individual items in the financial statements because different rates are used for assets, liabilities, revenue, and expense. In some extreme cases, the profit of the foreign subsidiary may turn into loss after translation. This distorts the performance of the foreign subsidiary.
Question 3 (10 marks)
Under the proportionate method of accounting for an interest in an unincorporated joint venture, each venturer records its share of each asset, liability, revenue, and expense of the venture in its ledger accounts. Therefore, the assets, liabilities, revenue, and expenses of the venturer in its financial statements include the venturer’s proportionate share of the related items of the venture on a line-by-line basis.
In contrast, under the equity method of accounting for an interest in an unincorporated joint venture, each venturer records its share of the venture’s profit or loss in the venturer’s own profit and loss account and reduces the carrying value of the investment account by the amount of cash or other assets distributed from the venture. The interest in the joint venture would be shown as a one-line amount in the balance sheet. In the venturer’s profit and loss account, the venturer’s share of the profit or loss of the venture would also be presented as a single amount.
Question 4 (10 marks)
a. UKS SAP requires that a contingent liability be accrued only when both of the
following two conditions are met: (1) it is probable that the outcome of a future event will confirm the loss and (2) the amount can be estimated with reasonable accuracy. The loss in this case should be accrued because it is probable that a settlement will be made and the amount can be reasonably estimated at the most likely amount of $70,000. The following journal entry should be made:
March 31
Estimated Loss from Litigation 70,000
Estimated Liability from Pending Lawsuit 70,000
b. In this case, the probability that the company may lose the lawsuit is only 50 percent, which is less than probable, according to the opinion of the company’s legal counsel, therefore the potential $10 million lawsuit does not need to be accrued. But as the amount is material and the probability of the loss is more than remote, the following information should be disclosed in the notes to the financial statements:
i) the nature of the contingency;
ii) the uncertainties which are expected to affect the ultimate outcome; and
iii) a prudent estimate of the financial effect, made at the date on which the financial statements are approved by the board of directors.
c. As the amount of the loss not covered by fire insurance can be reasonably estimated at $200,000 and the loss has already occurred, a journal entry should be made to record the loss and the loss shown as an extraordinary item on the income statement.
Estimated Fire Loss $200,000
Estimated Liability from Fire Loss $200,000
d. Assuming that the note receivable was discounted with recourse, the company would have to disclose the maturity amount and other information as a contingent liability. Now since it is clear that the debtor may not pay and the amount is known, the amount should be accrued by debiting Estimated Loss from Discounting Notes and crediting Estimated Liability from Discounting Notes.
Question 5 (10 marks)
Under the completion contract method, all income from the contract is related to the year of completion, even though only a small part of the earnings may be attributable to effort in that period. Previous periods receive no credit for their efforts. If a company waits until the production or service period is complete to recognize revenue, the income statement may not report meaningfully the periodic achievement of the company.
A better alternative is the Percentage-of-Completion method. This method relates recognition of revenue on long-term construction contracts to the activities of a firm in fulfilling these contracts. Under this method, a company recognizes revenues and costs on a contract as it progresses toward completion, rather than deferring recognition of these items until the contract is completed. The amount of revenue to be recognized each period is based on some measure of progress toward completion. The resulting income statement provides much more meaningful information than that produced under the completion of contract method.
PART II
Question 6 (20 MARKS)
a.
Cash Flow Statement
For the year ended 3 1/12/2001
Cash flows from operating activities:
Profit for the year 100000
Add: Depreciation 50000
Decrease
in debtors 30000
Increase in creditors 70000 150000
250000
Less: Profit from disposal of assets 20000
Increase in inventories 80000 100000
Net cash provided by operating activities 150000
Cash flows from investing activities:
Sale of plant assets 90000
Purchase of fixed assets (400000)
Net cash used in investing activities (310000)
Cash flows from financing activities:
Issue of ordinary share capital 150000
Issue of debentures 200000
Payment of cash dividend (30000)
Net cash provided by financing activities 320000
Net cash increase in cash 160000
Cash, opening balance 120000
Cash, ending balance 280000
(Students may also use the Hong Kong format.)
b. Issuing ordinary shares for assets or service or to pay debt does not involve cash. Exchange of assets do not involve cash.
Question 7 (20 marks)
1. Dec.31
Kao, Capital 38,000
Au, Capital 38,000
To record transfer of Kao’s equity in the partnership to Au.
2. Dec.31
Kao, Capital 38,000
Bains, Capital 19,000
Johnson, Capital 19,000
To record transfer of Kao’s equity in the partnership to Bains and Johnson.
3. Dec.31
Kao, Capital 38,000
Cash 5,000
Note payable to Kao 33,000
To record withdrawal of Kao from the partnership.
4. Dec.31
Kao, Capital 38,000
Lam, Capital ($2,000 x 4/7) 1,143
Ma, Capital ($2,000 x 3/7) 857
Cash 20,000
Note Payable to Kao 20,000
To record withdrawal of Kao from the partnership.
5. Dec.31
Equipment ($150,000 - $130,000) 20,000
Kao, Capital ($20,000 x .30) 6,000
Lam, Capital ($20,000 x .40) 8,000
Ma, Capital ($20,000 x .30) 6,000
To revalue the equipment and allocate the gain in value to the partners.
Dec. 31
Kao, Capital ($38,000 + $6,000) 44,000
Cash 10,000
Inventory 34,000
To record withdrawal of Kao from the partnership.
Question 8 (20 marks)
On Lowu’s book
Jan. 2, 2000
Leased Equipment 542,087
Obligations Under Finance Lease 542,087*
*PV130000+130000 (3.1699) = 542,087
Jan 2
Obligations Under Finance Leases 130,000
Cash 30,000
Dec. 31
Obligations Under Finance 88,791
Interest Expense 41,209*
Cash 130,000
*(542087 97 130000) x .10 = 41,209
Dec. 31
Amortization Expense on Leased Equipment 108,417*
Accumulated Amortization on Leased Equipment 108,417
*542,087/ 5 = 108,417
b. On Lowu’sbalance sheet:
Assets
Land, buildings, and equipment
Leased equipment 542,087
Less : Accumulated amortization on leased equipment 108,417
Net value 433,670
Liabilities
Current liabilities:
Obligations under finance leases-current portion 97,670*
Long-term liabilities:
Obligations under finance leases, exclusive of
$97,670 included in current liabilities 225,626
*Total obligations under finance leases, Dec. 31, 2000:
412087-130000+41209=323296
Interest for 2000: 323296 x .10 = 32330
Current obligation at Dec. 31, 1999: 130000-32330 = 97670
c. Lowu’s expenses related to the finance lease for year 2000
Interest expenses 41209
Amortization expense 108417
149626
Question 9 (20 marks)
a. Basic earnings per share:
Net income $860,000
Less: Dividends on preferred share (10,000 x $5) 50,000
Net income applicable to ordinary shares $810,000
Weighted average shares outstanding:
Jan. Ito Sept. 1 280,000 x 8/12 186,667
Sept. ito Dec. 31 336,000 x 4/12 112,000
298,667
Basic earnings per share (810,000 / 298,667) $ 2.71
b. Diluted earnings per share:
Test for dilution on convertible bonds:
Interest, net of tax, per $1,000 bond ($1,000 x .10 x .70) $70
Number of shares 40
Incremental EPS ($70 /40) 1.75
(dilutive)
Net income for basic earnings per share $810,000
Add Interest expense net of taxes on convertible bonds
($1,000,000 x .10 x .70) 70,000
Net income for diluted earnings per share $880,000
Weighted average share outstanding for basic EPS 298,667
Incremental shares:
On assumed exercise of options 30,000
Less: Shares assumed repurchased from proceeds
Of options (30,000x$22.50=$675,000;
$675,000 / $36=l 8,750 shares) 18,750 11,250
309,917
Shares assumed to be issued on conversion of bonds
($1,000,000! $1,000 x 40) 40,000
49,917
Diluted Earnings Per Share ($880,000 / 349,917) $ 2.51
c. Under the full disclosure principle, when a company has a complex capital structure (e.g., containing securities other than ordinary shares, for example, convertible bonds, stock options, etc.), additional information should be provided to users of the financial statements to reflect all potential dilution arising from the assumption that additional ordinary shares is issued from exercise of options or conversion of convertible securities. Investors may be misled if such information is not provided.