INTERMEDIATE ACCOUNTING 2 SECOND GRADING EXAMINATION, with a DETAILED ANSWER KEY

1. PFRSs are adopted from the standards issued by the a. IASC b. IASCF c. IASB d. FASB Use the following information for the next three questions: On January 1, 20x1, KISMET FATE Co., purchased inventory with a lis ...

1. PFRSs are adopted from the standards issued by the a. IASC b. IASCF c. IASB d. FASB Use the following information for the next three questions: On January 1, 20x1, KISMET FATE Co., purchased inventory with a list price of ₱4,400,000 and a cash price of ₱4,000,000 by issuing a noninterest-bearing note of ₱4,800,000 due on December 31, 20x3. 2. How much is the carrying amount of the note on initial recognition? a. 4,400,000 b. 4,000,000 c. 4,800,000 d. 3,786,309 B 4,000,000 – the cash price equivalent 3. How much is the interest expense in 20x1? a. 400,000 b. 279,830 c. 250,780 d. none of these C Solution: Trial and error approach First trial: (at 10%) Future cash flows x PV factor at x% = PV of note  4,800,000 X PV of 1 @ 10%, n=3 = 4,000,000 ₱  (4,800,000 x 0.751315) = 3,606,312 is not equal to 4,000,000 We need a substantially higher amount of present value. Therefore, we need to decrease substantially the interest rate. Let’s try 6%. Second trial: (at 6%) Future cash flows x PV factor at x% = PV of note  4,800,000 X PV factor at 6%, n=3 = 4,000,000  (4,800,000 x 0.839619) = 4,030,171 is not equal to 4,000,000 We need a slightly lower amount of present value. Therefore, we need to increase slightly the interest rate. Let’s try 7%. Third trial: (at 7%) Future cash flows x PV factor at x% = PV of note  4,800,000 X PV factor at 7%, n=3 = 4,000,000  (4,800,000 x 0.816298) = 3,918,230 is not equal to 4,000,000 In here, we need to perform interpolation. Looking at the values derived above, we can reasonably expect that the effective interest rate is a rate between 6% and 7%. To perform the interpolation, we will use the following formula: x% - 6% 7% - 6% Where: x% again is the effective interest rate. P a g e | 2 The formula is derived based on our expectation that the effective interest rate is somewhere between 6% and 7%. Notice that the lower rate appears in both the numerator and denominator of the formula while x % appears in the numerator. Let us substitute the amounts of present values computed earlier on the formula. 4,000,000 - 4,030,171 = (30,171) = 0.269 3,918,230 5 - 4,030,171 (111,941) The amount computed is added to 6% to derive the effective interest rate. The effective interest rate is 6.2695% (6% + .2695%). Interest expense in 20x1 = 6.2695% x 4,000,000 = 250,780 4. How much is the carrying amount of the note on December 31, 20x1? a. 4,250,780 b. 4,279,830 c. 4,400,000 d. 4,000,000 A (4,000,000 x 106.2695%) = 4,250,780 5. On January 1, 20x1, ABC Co., acquired transportation equipment in exchange for cash of ₱100,000 and ₱1,000,000 noninterest-bearing note payable due in 4 equal annual installments starting December 31, 20x1. The prevailing rate of interest for this type of note is 12%. How much is the current portion of the note on December 31, 20x2? a. 158,880 b. 177,945 c. 199,298 d. 223,214 Future cash flows – annual installments (₱1M ÷ 4) 250,000 Multiply by: PV of an ordinary annuity of ₱1 @12%, n=4 3.037349 Present value of note payable - Jan. 1, 20x1 759,337 Date Payments Interest expense Amortization Present value Jan. 1, 20x1 759,337 Dec. 31, 20x1 250,000 91,120 158,880 600,458 Dec. 31, 20x2 250,000 72,055 177,945 422,513 Dec. 31, 20x3 250,000 50,702 199,298 223,214 Dec. 31, 20x4 250,000 26,786 223,214 0 6. Kemp Company must determine the December 31, 2005, year-end accruals for advertising and rent expense. A P50,000 advertising bill was received January 7, 2006, comprising cost of P35,000 for advertisements in December 2006 issues, and P15,000 for advertisements in January 2006 issues of the newspaper. A store lease, effective December 16, 2004, calls for fixed rent of P120,000 per month, payable one month from the effective date and monthly thereafter. In addition, rent equal to 5% of net sales over P6,000,000 per calendar year is payable on January 31 of the following year. Net sales for 2005 were P9,000,000. In its December 31, 2005 balance sheet, Kemp should report accrued liabilities of a. 260,000 P a g e | 3 b. 185,000 c. 210,000 d. 245,000 D 35+ 60 + 150 7. ABC Co. is contemplating on issuing a 12%, 3-year, ₱1,000,000 bonds. Principal is due at maturity but interest is due semi-annually every July 1 and December 31. ABC determines that the current market rate on January 1, 20x1 is 14%. ABC Co. plans to issue the bonds on September 30, 20x1. How much is the estimated total proceeds from the issuance of the bonds on September 30, 20x1? a. 666,342 b. 962,563 c. 952,334 d. 992,563 Solution: Date Interest payments Interest expense Amortizatio n Present value Jan. 1, 20x1 952,335 July 1, 20x1 60,000 66,663 6,663 958,998 Sept. 30, 20x1 30,000 33,565 3,565 962,563 The estimated issue price pertaining to the bonds only on Sept. 30, 20x1 is ₱962,563. The total proceeds is computed as follows: Issue price pertaining to bonds only 962,563 Sold accrued interest (1M x 12% x 3/12) 30,000 Total issue price or cash proceeds 992,563 Only the accrued interest from July to Sept. is added to the issue price of the bonds because the last interest payment date was on July 1. 8. On January 1, 20x1, SALIENT PROMINENT Co. issued 1,000, ₱4,000, 12%, 3-year bonds for ₱4,412,336. Principal is due on December 31, 20x3 but interests are due annually every year-end. In addition, SALIENT incurred bond issue cost of ₱213,388.The effective interest rate before adjustment for transaction costs is 8%. How much is the carrying amount of the note on December 31, 20x1? a. 4,019,832 b. 4,198,948 c. 4,288,776 d. 4,138 ,843 D Solution: The carrying amount of the bonds on initial recognition is computed as follows: Issue price before transaction costs 4,412,336 Transaction costs (Bond issue costs) (213,388) Carrying amount - Jan. 1, 20x1 (net issue price) 4,198,948 Trial and error First trial: (using 10%)  (4M x PV of 1 @ 10%, n=3 ₱ ) + [(4M x 12%) x PV of an ordinary annuity of 1 @ 10%, n=3 ₱ ) = 4,198,948  (4M x 0.751315) + (480,000 x 2.48685) = 4,198,948  (3,005,260 + 1,193,688) = 4,198,948 is equal to 4,198,948 P a g e | 4 Since 10% exactly discounts the future cash flows to the initial carrying amount of the bonds, it shall be regarded as the effective interest rate. No further interpolation is needed. Date Interest payments Interest expense Amortization Present value Jan. 1, 20x1 4,198,948 Dec. 31, 20x1 480,000 419,895 60,105 4,138,843 Use the following information for the next two questions: On January 1, 20x1, SPITEFUL MALICIOUS Co. issued 1,000, ₱4,000, 10%, 3-year bonds for ₱3,807,852. Principal is due on December 31, 20x3 but interests are due annually every year-end. The effective interest rate is 12%. SPITEFUL Co. incorrectly used the straight line method instead of the effective interest method to amortize the discount. 9. What is the effect of the error on the carrying amount of the bonds on December 31, 20x1? (over) understated a. 7,107 b. (7,107) c. 6,341 d. (6,341)