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UNIVERSITY OF ILLINOIS AT URBANA-CHAMPAIGN

College of Business
Department of Accountancy
Accountancy 301 Fall 2015
Instructor: Theodore Sougiannis
Mid-Term Examination 2

NAME (Please Print): ANSWER KEY

Network ID:

Section (12:30pm [AE6], 2:00pm [AEB]):

Directions:

1. Place your name, network ID, and section number on this page.

2. This is a closed-book, closed-note exam to be performed individually. You cannot receive


help from others. If you receive help from others, you will receive a score of zero for the exam.

3. You may use a calculator. You cannot use: 1) a computer or similar device; 2) a device that is
capable of communicating with other devices such as a cell phone.

4. Read each question carefully before answering it. If a question is unclear, clearly and
explicitly state a reasonable assumption and proceed based on that to answer the question.
Clearly indicate your choice in the multiple choice questions. For the problems, please write
neatly and explain clearly your arguments within the space provided below the questions. Partial
credit will be given only when statements/calculations are clear and relate to the question asked.

5. The highest possible score is 150 points.

6. You have 80 minutes to complete the exam.

7. When you are finished, submit your completed exam booklet.

Scores

I. Multiple Choice Questions (20 questions, 5 points each)

II. Task Based Simulation (25 points)

III. Critical Thinking Case (25 points)

Total (of 150)

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Part I: Multiple choice questions

1. If a company incurs disposition obligations as a result of acquiring an asset:


a. The company recognizes the obligation at fair value when the asset is acquired.
b. The company recognizes the obligation at fair value when the asset is disposed.
c. The company records the difference between the fair value of the asset and the
obligation when the asset is acquired.
d. None of these answer choices are correct.

2. Juliana Corporation purchased all of the outstanding stock of Caldwell Inc., paying $2,700,000
cash. Juliana assumed all of the liabilities of Caldwell. Book values and fair values of
acquired assets and liabilities were:

Book Fair Value


Value
Current assets (net) $420,000 $450,000
Property, plant, & equip. 1,600,000 2,250,000
(net)
Liabilities 500,000 600,000

Juliana would record goodwill of:


a. $1,180,000.
b. $ 600,000.
c. $ 880,000.
d. $ 100,000.

3. In a nonmonetary exchange of equipment, if the exchange has commercial substance, a gain is


recognized if:
a. The fair value of the equipment received exceeds the book value of the equipment
received.
b. The book value of the equipment received exceeds the fair value of the equipment
given up.
c. The fair value of the equipment surrendered exceeds the book value of the
equipment given up.
d. None of these answer choices are correct.

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Use the following to answer questions 4 and 5 below:

Alamos Co. exchanged equipment and $18,000 cash for similar equipment. The book value and
the fair value of the old equipment were $82,000 and $90,000, respectively.

4.Assuming that the exchange has commercial substance, Alamos would record a gain/(loss) of:
a. $26,000.
b. $ 8,000.
c. $(8,000).
d. $ 0.

5. Assuming that the exchange lacks commercial substance, Alamos would record a gain/(loss)
of:
a. $26,000.
b. $ 8,000.
c. $(8,000).
d. $ 0.

6. Interest may be capitalized:


a. On routinely manufactured goods as well as self-constructed assets.
b. On self-constructed assets from the date an entity formally adopts a plan to build a
discrete project.
c. Whether or not there is specific borrowing for the construction.
d. Whether or not there are actual interest costs incurred.

7. Depreciation:
a. Is always considered a period cost.
b. Could be a product cost or a period cost depending on the use of the asset.
c. Is usually based on the declining-balance method.
d. Per books is usually higher than MACRS in the early years of an asset's life.

Use the following to answer questions 8 and 9 below:

On June 30, 2016, Prego Equipment purchased a precision laser-guided steel punch that has an
expected capacity of 300,000 units and no residual value. The cost of the machine was $450,000
and is to be depreciated using the units-of-production method. During the six months of 2016,
24,000 units of product were produced. At the beginning of 2017, engineers estimated that the
machine can realistically be used to produce only another 230,000 units. During 2017, 70,000
units were produced.

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8. Prego would report depreciation in 2016 of:
a. $36,000.
b. $43,900.
c. $18,000.
d. $21,950.

9. Prego would report depreciation in 2017 of:


a. $135,230.
b. $126,000.
c. $108,000.
d. $105,000.

10. Jung Inc. owns a patent for which it paid $66 million. At the end of 2016, it had accumulated
amortization on the patent of $16 million. Due to adverse economic conditions, Jung's
management determined that it should assess whether an impairment loss should be
recognized for the patent. The estimated undiscounted future cash flows to be provided
by the patent total $43 million, and the patents fair value at that point is $35 million.
Under these circumstances, Lester:
a. Would record no impairment loss on the patent.
b. Would record a $7 million impairment loss on the patent.
c. Would record a $15 million impairment loss on the patent.
d. Would record a $31 million impairment loss on the patent.

11. The replacement of a major component increased the productive capacity of production
equipment from 10 units per hour to 18 units per hour. The expenditure should be debited
to:
a. Repairs.
b. Equipment.
c. Maintenance.
d. Gain from repairs.

12. In January 2016, Vega Corporation purchased a patent at a cost of $200,000. Legal and filing
fees of $50,000 were paid to acquire the patent. The company estimated a 10-year useful
life for the patent and uses the straight-line amortization method for all intangible assets.
In January, 2019, Vega spent $40,000 in legal fees for an unsuccessful defense of the
patent and the patent is no longer usable. The amount charged to income (expense and
loss) in 2019 related to the patent should be:
a. $ 40,000.
b. $ 65,000.
c. $215,000.
d. $ 25,000.
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13. Which of the following is not an indicator that revenue can be recognized over time?
a. The seller is enhancing an asset that the buyer controls as the service is performed.
b. The customer consumes the benefit of the sellers work as the seller performs the
service.
c. The seller is creating an asset that has an alternative use to the seller, and the
seller can receive payment for its progress even if the customer cancels the
contract.
d. None of the other answers is correct.

Use the following to answer questions 14, 15 and 16 below:

On July 15, 2016, Ortiz & Co. signed a contract to provide EverFresh Bakery with an
ingredient-weighing system for a price of $90,000. The system included finely tuned scales
that fit into EverFreshs automated assembly line, Ortizs proprietary software modified to
allow the weighing sytem to function in EverFreshs automated system, and a one-year
contract to calibrate the equipment and software on an as-needed basis. (Ortiz competes with
other vendors who offer ongoing calibration contracts for Ortizs systems.) If Ortiz was to
provide these goods and services separately, it would charge $60,000 for the scales, $10,000
for the software, and $30,000 for the calibration contract. Ortiz delivered and installed the
equipment and software on August 1, 2016, and the calibration service commenced on that
date.

14. How many performance obligations exist in this contract?


a. 0
b. 1
c. 2
d. 3

15. Assume that the scales, software and calibration service are all separate performance
obligations. How much revenue will Ortiz recognize in 2016 for this contract?
a. $0
b. $63,000
c. $74,250
d. $90,000

16. Assume that the scales, software and calibration service are viewed as one performance
obligation. How much revenue will Ortiz recognize in 2016 for this contract?
a. $0
b. $37,500
c. $63,000
d. $90,000

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17. What is the effect of bad debts on revenue recognition?
a. The seller must believe it is probable it will collect the amounts it is entitled to
collect.
b. Bad debts must be of a remote likelihood in order to recognize revenue.
c. Bad debts are deducted from revenue to calculate net revenue on the income
statement, similar to sales returns.
d. Bad debts are ignored when determining whether to recognize revenue, but
recognized as an expense on the income statement.

Use the following to answer questions 18, 19, and 20 below:

On June 1, 2016, Emmet Property Management entered into a 2-year contract to oversee
leasing and maintenance for an apartment building. The contract starts on July 1, 2016.
Under the terms of the contract, Emmet will be paid a fixed fee of $50,000 per year and
will receive an additional 15% of the fixed fee at the end of each year provided that
building occupancy exceeds 90%. Emmet estimates a 30% chance it will exceed the
occupancy threshold, and concludes the revenue recognition over time is appropriate for
this contract.

18. Assume Emmet estimates variable consideration as the expected value. How much
revenue should Emmet recognize on this contract in 2016?
a. $25,000
b. $26,125
c. $28,750
d. $50,000

19. Assume Emmet estimates variable consideration as the most likely amount. How much
revenue should Emmet recognize on this contract in 2016?
a. $25,000
b. $26,125
c. $28,750
d. $50,000

20. Assume that Emmet accrues revenue each month, and estimates variable consideration as
the most likely amount. On November 1, Emmet revises its estimate of the chance the
building will exceed the 90% occupancy threshold to a 70% chance. What is the total
amount of revenue Emmet should recognize on this contract in November of 2016?
a. $3,125
b. $4,167
c. $4,792
d. $7,291

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Part II. Task Based Simulation (25 points)

McCombs Contractors received a contract to construct a mental health facility for $2,500,000.
Construction was begun in 2015 and completed in 2016. Cost and other data are presented below:

2015 2016
Costs incurred during the year $1,500,000 $1,300,000
Estimated costs to complete 1,200,000 0
Billings during the year 1,200,000 1,300,000
Cash collections during the year 1,000,000 1,500,000

A) Assume that McCombs recognizes revenue on this contract over time according to percentage of
completion.

1. (3 points) Compute the amount of gross profit recognized during 2015 and 2016.

2015: [$2,500,000 ($1,500,000+$1,200,000)] = ($200,000) estimated loss recognized

2016: [$2,500,000 ($1,500,000+$1,300,000)] = ($300,000) total loss in the contract

2016: $200,000 of the total loss of $300,000 was already recognized in 2015. Therefore, $100,000 loss
should be recognized in 2016 ($300,000-$200,000)

2. (2 points) Explain why it is called gross profit and not net profit.

It is like gross margin and some additional operating expenses such as general and administrative
expenses need to be subtracted to get to a net profit.

3. (8 points) Prepare all journal entries to record costs, billings, collections, and profit recognition for
2015 and 2016. Briefly explain the logic in each entry (dont repeat the logic for a similar entry in both
years).

2015: Construction in progress $1,500,000


Cash and/or A/P 1,500,000
To accumulate actual costs incurred in 2015. It is an asset because the firm expect to receive future
benefits (profit) from using its cash and from financing (A/P) in its operating activities (build a
facility).

Accounts receivable $1,200,000


Billings on construction contract 1,200,000
To bill the customer by creating an asset to be collected, accounts receivable.

Cash $1,000,000
Accounts receivable $1,000,000
To recognize cash collections from the customer during the year.

Cost of construction $1,588,889


Construction in progress (loss) 200,000
Revenue from long-term contracts 1,388,889 [2,500,000x(1,500,000/2,700,000)]
To recognize a portion of the revenue for 2015.

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2016: Construction in progress $1,300,000
Cash and/or A/P 1,300,000

Accounts receivable $1,300,000


Billings on construction contract 1,300,000

Cash $1,500,000
Accounts receivable $1,500,000

Cost of construction $1,211,111


Construction in progress (loss) $100,000
Revenue from long-term contracts $1,111,111 (2,500,000-1,388,889)

Billings on construction contract $2,500,000


Construction in progress $2,500,000
To close all contract related accounts at the end of the contract period.

4. (5 points) What is the final (net) impact (dollar amount) of all journal entries you made in 2015 and
2016 on the income statement, balance sheet, and the cash flow statement of McCombs?

The net impact will be $300,000 loss (the income statements of 2015 and 2016 will show losses of
$200,000 and $100,000 respectively). Then, retained earnings will be lower by $300,000 and cash
will be lower by $300,000 or accounts payable will be higher by $300,000 on the balance sheet of
2016. Cash from operating activities will be lower by $300,000 by the end of 2016 if all A/P have
been paid or by some smaller amount if some A/P are still unsettled.

B) Assume that McCombs recognizes revenue upon project completion.

5. (2 points) Compute the amount of gross profit recognized by McCombs during 2015 and 2016.

2015: Again the loss of $200,000 (calculated as above) needs to be recognized because of
conservatism.

2016: $100,000 loss (the remaining out of the $300,000 loss from the contract).

6. (3 points) Prepare only the journal entries for both 2015 and 2016 that differ from the entries you
prepared above under the percentage of completion method.

2015: Loss on Long term contract $200,000


Construction in progress $200,000

2016: Cost of construction $2,600,000


Construction in progress (loss) $100,000
Revenue from long-term contracts $2,500,000

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7. (2 points) Will the final (net) impact (dollar amount) of all journal entries in 2015 and 2016 on the
income statement, balance sheet, and the cash flow statement of McCombs differ between the two
revenue recognition methods? Explain your answer and indicate the dollar difference if any.

The net impact will be the same as above. The economic (cash) impact of the contract cannot be
changed by the application of different accounting methods.

Part III: Critical Thinking Case (25 points)

Early in 2007 Calegari Mining paid $3 million to obtain the rights to explore for and extract iron ore in
Tennessee over the following 8 years. For this, it also acquired equipment costing $1 million with a useful
life of 8 years and to be depreciated using the straight line method. Exploration costs totaled $1,500,000,
and development costs of $5 million were incurred in preparing the mine for extraction during 2007 and
2008. In addition, an asset retirement obligation of $500,000 was recognized to restore the land to its
original condition at the end of extraction.

1. (3 points) What is the initial cost of the mine? Explain your answer.

Initial cost: $3,000,000+$1,500,000+$5,000,000+$500,000=$10,000,000

2. (2 points) What values and in what accounts are shown on the companys balance sheet at the end of
2008?

Assets: Calegari Mine $10,000,000 and Equipment $1,000,000


Liabilities: Asset Retirement Obligation Calegari Mine $500,000

3. Extraction was planned to start on January 2, 2009. However, due to the financial crisis of 2008, the
price of iron ore decreased to the point that made the mine uneconomical to operate. The CEO of Calegari
announced that the decision was made to wait for maximum two years, 2009 and 2010, and see if prices
will increase and make the mine economical to operate.

a) (10 points) Clearly indicate and explain the accounting (journal entries) and reporting (related
disclosures) required in 2009 and 2010 while the mine does not operate.

Since the equipment stays idle, it needs to be depreciated and so in each year the entry is:
Depreciation expense Equipment $125,000 ($1,000,000/8years)
Accumulated depreciation Equipment $125,000

The asset retirement obligation (ARO) may stay on the balance sheet (conservatism) or may be
reversed. The CEO will ask for its reversal because the debt-to-equity ratio is higher with the ARO
in the books. Since there is no extraction taking place in the mine, the argument that there is no
related liability for restoration stands and it can be eliminated with the following entry:

Asset Retirement Obligation Calegari Mine $500,000


Calegari Mine $500,000

The firm should provide footnote disclosures discussing the situation with this mine and the
reversal of the ARO.

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b) (5 points) Early in 2011 iron ore prices stayed at levels that were making extraction uneconomical and
the management decided to abandon the mine. Clearly indicate and explain the accounting (journal
entries) and reporting (related disclosures) required in 2011 for the abandonment of this investment.

The equipment will be sold at some (maybe scrap) value and a loss will be recognized:
Cash $XX (sale value)
Accumulated depreciation $500,000 (125,000x4 years)
Loss on sale of equipment $XXX
Equipment $1,000,000

A loss on discontinued operations will be recognized from abandoning the mine:


Loss on discontinued operations $9,500,000
Calegari Mine $9,500,000

Footnotes will explain the sale of the equipment and the abandonment of the mine.

c) (5 points) Late in 2010 iron ore prices increased to levels that made extraction economical and the
management decided to start extraction on January 2, 2011. Clearly indicate and explain the accounting
(journal entries) and reporting (related disclosures) required in 2011 (use numbers to the extent available).

First the ARO needs to be reestablished:


Calegari Mine $500,000
Asset Retirement Obligation Calegari Mine $500,000

The equipment needs to be depreciated for 2011:


Depreciation expense Equipment $125,000
Accumulated depreciation Equipment $125,000

Depletion expense needs to recognized for 2011:


Depletion expense $XXX (Depletion rate per ton x tons extracted)
Calegari Mine $XXX

The sales related entries also need to be made.


Footnotes will explain the reestablishment of the ARO and information on the depletion expense.

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