ACCOUNTING 201/FALL 2008

SOLUTION -- FINAL EXAM

Question 1: Long-lived assets (10 points)
a. Gamma Company purchases land as a factory site for $800,000 during 2007. Legal fees of
$1,500 were paid for title investigation. Gamma hired an independent contractor to tear down
two old buildings on the site. Gamma then constructed its own factory on the land. Construction
was complete as of December 29, 2007. The company paid $40,000 to raze the old buildings.
Payment to an engineering firm was made for drawing the factory plans, $60,000. The total
costs of direct labor, materials, and direct overhead associated with construction were
$2,000,000. At December 31, 2007, Gamma had outstanding accounts payable related to
construction materials purchases (included in the $2 million above) of $180,000. Avoidable
interest associated with the construction was $140,000.
Determine the cost of the land and the cost of the factory that are included on the balance sheet
of Gamma at December 31, 2007.
Land
Factory
Land
$ 800,000
Legal Fees
1,500
Razing Costs
40,000
Plans
$
60,000
Construction
2,000,000
Interest
140,000
$ 841,500
$2,200,000
b. Assume that the factory from part a is instead a building that Gamma will use to conduct its
own research and development. It is a long-range research facility for use in current and future
projects. Determine the cost of the facility (not the land) that Gamma is allowed to include on
the balance sheet at December 31, 2007.
$2,200,000 (the same answer as to part a)
Question 2. Equity method investments (5 points)
Rocket acquires an equity stake in Grady Inc. on January 1, 2008. Rocket purchases 1,000,000
shares of Grady at $1 per share. This investment represents a 25% interest in Grady. Gradys
book value of equity on January 1, 2008 is $3,600,000. Gradys net income for 2008 is
$100,000. Grady declares and pays $40,000 in dividends (in total to all shareholders) during
2008. Gradys share price at December 31, 2008 is $1.10.
What is Rockets *pretax* income for the year ended Dec 31, 2008 related to the Grady investment?
25,000
What is the investment-related asset associated with Grady that Rocket should report on its
December 31, 2008 balance sheet?
1,000,000 + 25,000 - 10,000 = 1,015,000

Question 3. Error correction

On December 31, 2006, Shane Co. receives $10,000 as a prepayment for renting office space to a
third party for the calendar year 2007. At the time of receipt, Shane Co. debits Cash and credits
Rental revenue. Shane closes its books for 2006 without making any adjustments associated
with this transaction for the reporting period ending December 31, 2006.
1.

Assume Shane discovers the error during 2007 before the 2007 books are closed.
a) What journal entry (entries) should Shane Co. make, if any, during 2007 related to this
transaction?
Retained earnings
Rental revenue

10,000

Or, Retained earnings

Unearned rental revenue
Unearned rental revenue
Rental revenue

10,000

10,000

10,000
10,000
10,000

b) In the 2007 annual report, what amount should Shane report for rental revenue for 2006?
ZERO
2. Assume Shane discovers the error during 2008 before the 2008 books are closed.
a) What journal entry (entries) should Shane Co. make, if any, during 2008 related to this
transaction?
NONE
b) In the 2008 annual report, what amounts should Shane report for rental revenue for 2007
and 2006, respectively?
2007: $10,000
2006: ZERO
Question 4. Revenue recognition
A. Long-term construction contracts
In 2004, Potter Construction Co. began construction work under a three-year contract. This
contract is Potters only contract. The contract price is $300,000. Potter uses the percentage-ofcompletion method for financial accounting purposes. The income to be recognized each year is
based on the proportion of costs incurred to total estimated costs for completing the contract.
The financial statement presentations relating to this contract at December 31, 2004, follow:

At December 31, 2004, Potter reported the following on its balance sheet:
Accounts receivable construction contract billings
Construction in progress
$108,000
Less: Contract billings
94,000
Cost of uncompleted contract in excess of billings

$54,000

14,000

For the year ended December 31, 2004, Potter reported the following on its income statement:
Profit (before tax) on construction contract

$21,600

How much cash did Potter collect on this contract during 2004?
Contract billings to date =
Accounts receivable still outstanding as of 12/31/04
Portion of contract billings collected to date =

94,000
54,000
40,000

Based on information available as of December 31, 2004, what is the estimated total expected
profit (before tax) that Potter will earn on this contract?
108,000 revenue recognized/300,000 total expected revenue = 36% complete
Profit recognized to date = 21,600 = .36 * expected total profit.
Expected total profit = 21,600/.36 = 60K.
OR
The ratio of gross profit to revenue recognized in 2004: 21,600/108,000 = .20
So total expected profit on a $300,000 contract is $300K * .20 = $60,000
B. Other revenue recognition (15 points)
Joes College Services Company has three divisions.
1. Division #1 operates health clubs called Sweat near college campuses. Students pay a onetime nonrefundable initiation fee of $120 and sign a contract that allows for full use of the
facilities for one year at an additional charge of $15/month. Students are allowed to renew up to
three times (i.e., for a total membership period of four years). The monthly fee covers Sweats
operating costs. Based on a reliable statistical analysis, Joes determines that the average student
is a health club member for a total of three years.
Assume Sweat initiates 1,000 new members on January 1, Year 1. For each of the following
years listed, indicate what Sweat should report as initiation fee revenue related to the $120 paid
by these 1,000 customers.
Year 1: 40,000
Year 2: 40,000
Year 3: 40,000
Year 4: 0

2. Division #2 operates a retail chain called JCs, which is a discount retailer of college-related
necessities. JCs charges a membership fee of $40 for unlimited shopping at any of its 53
locations nationwide for one year from the initiation date. The fee is fully refundable at any time
during that year. Students are welcome to rejoin in subsequent years, but they will pay a new
membership fee. Joes extremely reliable statistical analysis of its large and homogeneous
customer base using years worth of historical data (even the SEC considers it to be reliable)
reveals that 50% of students, on average, request a refund of the $40 initiation fee during the year.
Assume JCs gets 1,000 members on October 1, year 1. Joes has a Dec 31 fiscal year end.
What should JCs report as membership revenue for the three months ended Dec 31, year 1?
Half the students will request a refund, on average, so Joes cannot recognize any revenue
for these students. Joes can recognize the remaining revenue ratably over the year. So,
* 1/4 year * $40 = $5 per customer = $5,000.
3. Division #3 offers customized e-mail notification services about social and cultural events on
campus. The service is customized in that students answer an extensive survey about their
interests and only relevant events are listed in the email that is distributed. Students must sign a
contract for four years of this service at $5/month. The $240 fee, received in total upfront, is
only refundable if Joes terminates the contract, which is highly unusual.
The cost of conducting the survey and customizing the students account is 95% of the total cost
of providing the email service over the four year period. The cost of compiling the lists of events
and distributing them based on the information in the database is the remaining 5%.
Assume Joes signs up 1,000 students for its email notification service on January 1, year 1.
What should Joes report as revenue related to these customers in each of the following years:
Year 1: 60,000
Year 2: 60,000
Year 3: 60,000
Year 4: 60,000
Question 5. Intangibles, R&D, and changes in accounting estimates
1. (3 points) Segal Inc. incurred the following costs during the year ended December 31, 2007:
Personnel costs:
Persons involved in research and development projects
Consulting fees paid to outsiders who perform R&D activities
Equipment acquired that will have alternate future uses in future
research and development projects
Depreciation for 2007 on above equipment
Indirect costs reasonably allocable to research and development projects

500,000
250,000
1,000,000
200,000
300,000

What is the total amount to be classified and expensed as research and development in 2007?
1,250,000

2. Amare Co. acquires a patent for $150 on January 1, 2006. The patented technology is
expected to be a source of cash flows for at least 15 years. Amare believes that if it were to
decide to sell the patent in five years, it is likely that it could sell the patent for approximately
$50. However, Amare does not intend to sell it. What is the dollar amount of amortization that
Amare should record for the year ended Dec 31, 2006? 10 (Dont consider salvage value.)
3. Wade Co. purchased the license to distribute a consumer product on January 1, 2004, for
$150,000. It is expected that this product will generate cash flows for an indefinite period of
time. The license has an initial term of 5 years. Wade can renew the license indefinitely for
successive 5-year terms by paying a nominal fee. Wade Co. has the intent and ability to renew
the license. What amount should be amortized for the year ended December 31, 2004? ZERO:
Because the license can be easily renewed at nominal cost, it has an indefinite life. Thus, it
is not amortized.
4. Elton Co. purchased a patent from Garnett Co. for $1,000,000 on January 1, 2006. The patent
is being amortized over its remaining legal life of ten years, expiring on January 1, 2016. During
2008, Elton Co. determined that the economic benefits of the patent would not last longer than 6
years from the date of acquisition. What amount should be reported in the balance sheet for the
patent, net of accumulated amortization, at December 31, 2008?
Wade should report the patent at $600,000 (net of $400,000 of accumulated amortization)
on the balance sheet. The computation of accumulated amortization is as follows:
Amortization for 2004 and 2005 ($1 mm/10*2 years)
2006 Amortization ($1 mm - $200K)/(6-2 years)
Total

200,000
200,000
400,000

5. On July 31, 2003, Wallace Co. paid $2,000,000 to acquire all of the common stock of Ming
Corp., which became a division of Wallace. It was determined at the date of the purchase that
the fair value of the identifiable net assets of Ming was $1,600,000. At December 31, 2003, it is
determined that the fair value of the Ming Division is $1,500,000, and the fair value of the
identifiable net assets of Ming (excluding goodwill) is $1,150,000. The book value of the
identifiable net assets of the Ming division, excluding goodwill, is $1,300,000 on Dec 31, 2003.
a. Compute the amount of goodwill, if any, recognized on July 31, 2003.
2,000,000-1,600,000 = 400,000
b. Determine the impairment loss, if any, to be recorded on December 31, 2003.
FV(Ming) =
BV(Ming) including goodwill = (1,300 + 400K)
Goodwill is potentially impaired.
Compute implied goodwill:
Book value of goodwill
Implied fair value of goodwill = (1,500 - 1,150)

1,500,000
1,700,000

400,000
350,000

Impairment loss:

50,000

Question 1. Coca Cola Inc. The equity method

1) What amount should Coca Cola Inc. have recognized in income for the year ended Dec 31,
2007 related to its investment in these bottling enterprises?
$1,868 * .25 = 467
2) Based on the information provided in the last sentence of the paragraph directly under the
table, what is the amount of Coca Colas investment in these enterprises reported on its balance
sheet at December 31, 2007?
1122 + (0.25*15,894) = 5,095.5
3) The last paragraph of the footnote under the table states: If valued at the December 31, 2007
quoted closing prices of shares actively traded on stock markets, the value of our equity method
investments in these publicly traded bottlers would have exceeded our carrying value by
approximately $5.8 billion. Indicate the adjusting journal entry Coca Cola made, if any, at
December 31, 2007 to reflect this fact. NONEdont write up to FV.
B. Coca Cola describes its long-term asset impairment testing as follows:
For the noncurrent assets listed in the table below, we perform tests of impairment as appropriate. For applicable
assets, we perform these tests when certain conditions exist that indicate the carrying value may not be recoverable.
For other applicable assets, we perform these tests at least annually or more frequently if events or circumstances
indicate that an asset may be impaired.

(i) Which of the five asset categories listed above are tested when certain conditions exist that
indicate the carrying value may not be recoverable?
Property, plant and equipment, net
Amortized intangible assets, net

(ii) Which of the five asset categories listed above are tested at least annually or more
frequently if events or circumstances indicate that an asset may be impaired?
Trademarks with indefinite lives
Goodwill
Other intangible assets not subject to amortization

(iii) Which of the five asset categories listed above do not need to be tested for impairment?
NONE

Question 2. Revenue recognition and construction at Marriott Inc.

Upon the redemption of points, we recognize as revenue the amounts previously deferred. Our liability for the
Marriott Rewards program was $1,392 million at year-end 2007 and $1,231 million at year-end 2006.

(i) Assume that Marriott bills and collects fees related to this program of $2,000 million from its
managed and franchised hotels during the year end December 31, 2007. How much revenue did
Marriott recognize related to this rewards program for the year ended December 31, 2007?
1,231 + 2,000 X = 1,392

X = 1839

Although we discussed the fair value terminology primarily for assets, it applies to estimates of
fair values of liabilities as well. Is the fair value estimate a Level 1 estimate, Level 2 estimate, or
Level 3 estimate? How do you know?
Level 3 it is based on a model that uses unobservable inputs.
(i) What was Marriotts total interest cost (as this term is used in your book and in class) for
the year ended Dec 31, 2007?
Total interest cost =

interest expense + capitalized interest

184 + 49 = 233 million

(ii) If capitalizable construction costs incurred during the year ended December 31, 2007
excluding capitalized interest were $452, what is the aggregate cost basis of constructed hotels
that was transferred into other PPE categories during the year ended December 31, 2007?
215 + 49 + 452 X = 216

X=500

Question 3. Washington Mutual Bank -- Marketable securities

Assume WAMU had sold its entire portfolio of AFS securities described in Note 5 on December
31, 2007 at the fair values reported in the note.
a) What would be the impact on earnings before income taxes for the year ended December 31,
2007?
($193 - $442) = 27,789 27,540 = 249
b) What would be the impact on net income for the year ended December 31, 2007?
Your answer to (a) * 0.7
$249 * 0.7 = 174.3

c) What would be the impact on other comprehensive income for the year ended December 31,
2007?
If all the securities are sold, then the balance of the AOCI account associated with
investment securities should be zero. Currently, the AOCI account has an unrealized
after-tax debit (loss) balance of $161. Thus, WAMU would have had $161 unrealized
gains, after tax OCI associated with investment securities.
You can also get to this # with slightly different logic by observing that WAMU starts with
a debit balance of (61). All of this would be reversed. Thus, the credit for the year would
have been 61. But, the actual debit was $100. So, the impact would be a $161 credit.
d) What would be the net realized gain or loss associated with AFS securities included in pretax
income on the income statement for the year ended December 31, 2007? (Be sure to indicate
whether it is a gain or a loss.)
249 + 319 = 568
A $319 net loss (either from the footnote or the SCF) was realized on actual sales during
the year. The realized loss on these hypothetical transactions = 249 (answer to part a).
Question 2. Near the end of the operating section of the SCF (p. 21), WAMU reports a
reconciling item for a Net decrease in trading assets of 2,761 for the year ended December 31,
2007. This amount is being added back because:
i) The amount in net income associated with trading securities is $2,761 less than the
net cash flows associated with purchasing and selling trading securities.
Question 3. WAMUs discussion of fair value measurement follows.

Fair value is defined as _________X_________ at the measurement date.

The missing line from WAMUs fair value measurement discussion labeled X said:
D) the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants