JRE300: Fundamentals of Accounting and Finance

MIDTERM EXAMINATION (30% of Final Grade): Fall 2015

Time Allowed: 2 Hours

LAST NAME _________________________________________

FIRST NAME_________________________________________

STUDENT NUMBER:__________________________________

PLEASE INDICATE YOUR INSTRUCTOR:

S. Douglas___________ F. Tolias___________

Instructions:

Write all of your answers on the examination paper. If you need additional space, use the back of the page facing the question and clearly identify the question being answered.

This is a closed book exam. One double-sided 8.5'x11' hand-written or typed aid sheet containing formulas/notes is permitted. Non-programmable calculators are permitted.

Pencil or pen may be used. However, papers written in pencil or papers with white outs will not be re-marked.

Question Marks Marks Awarded

1 17

2 17

3 11

4 10

5 15

6 30

Total 100

1

QUESTION 1 – Total of 17 Marks

You are the sole shareholder of a merchandising company called JBS Resellers Inc. The company began operations on January 1, 2015. You have just approached the bank seeking an operating line of credit. The bank has asked for a set of current quarterly financial statements as a starting point in negotiations. The following business transactions occurred during the first quarter ended March 31, 2015:

Jan 1 Shareholder invested $100,000 in exchange for common shares.

Jan 1 Signed a lease for office space on January 1st. The lease stipulated quarterly payments, due at the beginning of each quarter, of $12,000. The first payment was made at the time of signing.

Jan 3 Purchased 1000 units of inventory on account for $20,000.

Jan 20 Purchased office equipment for $6,000, paying $2,500 in cash and signing a 30 day note payable for the remainder.

Jan 26 Paid $20,000 in full settlement of the inventory purchase on January 3rd

Feb 20 Purchased 500 units of inventory on account for $12,000.

Feb 24 Paid the remainder to the amount owing on the equipment purchased on January 20th.

Mar 9 Received and paid bill for $1,500 for advertising for the current month.

Mar 20 Hired a part-time employee to assist with marketing. His start date is April 1st.

Mar 23 Sold 1200 units of inventory on account for $43,000. The terms of the shipment were fob shipping point. The company uses a perpetual inventory system with a first-in, first out policy for inventory.

Mar 31 Paid $1,000 cash dividends to shareholder.

The company intends to depreciate its office equipment on a straight-line basis over 5 years. It is anticipated that the equipment will be worth $1,000 at the time it is sold. The CFO has determined that bad debts average 2% of sales in this industry.

PART A (9 marks)

Journalize the transactions above using the correct account names. Be sure to include any year-end adjusting entries. Also, if an entry is not required for a transaction, please explain.

2

JOURNAL ENTRIES – .5 mark each entry (except march 23 COGS entry= 1 full mark) = 6.5 (6 mark max)

Jan 1 Cash ............................................................................................ 100,000Common Shares .................................................................... 100,000

1 Prepaid Rent ............................................................................... 12,000Cash ...................................................................................... 12,000

3 Inventory .................................................................................... 20,000Accounts Payable .................................................................. 20,000

20 Office Equipment ........................................................................ 6,000Note Payable......................................................................... 3,500

Cash....................................................................................... 2,500

26 Accounts Payable ........................................................................ 20,000Cash ...................................................................................... 20,000

Feb 20 Inventory .................................................................................... 12,000Accounts Payable................................................................... 12,000

24 Note Payable............................................................................... 3,500Cash....................................................................................... 3,500

Mar 9 Advertising Expense .................................................................... 1,500Cash ...................................................................................... 1,500

20 NO ENTRY – NOT AN ECONOMIC EVENT ......................................

23 Accounts Receivable .................................................................... 43,000Sales Revenue........................................................................ 43,000

23 Cost of Good Sold ........................................................................ 24,800Inventory 24,800

($20 x 1000 + $24 x 200)

31 Dividends .................................................................................... 1,000Cash....................................................................................... 1,000

ADJUSTING ENTRIES – 1 mark each entry = 3 TOTAL

31 Rent Expense .............................................................................. 12,000Prepaid Rent.......................................................................... 12,000

31 Depreciation Expense .................................................................. 250Accumulated Depreciation..................................................... 250

3

($6,000-1,000)/5*3/12months (also accept 5,000/5*70/365days)

31 Bad Debt Expense ....................................................................... 860Allowance for Doubtful Accounts........................................... 860(2% * 43,000)

PART B (8 marks)Prepare an income statement and balance sheet for the quarter ended March 31, 2015.

Statement of Earnings, quarter ended March 31, 2015

Sales revenue $ 43,000Cost of Goods Sold 24,800Gross Margin $ 18,200

ExpensesAdvertising expense $1,500Rent Expense 12,000Depreciation Expense 250Bad Debt Expense 860 14,610

Net earnings $ 3,590

Balance Sheet, as at March 31, 2015

Current assetsCash $ 59,500Accounts receivable $ 42,140Inventory $ 7,200 $108,840

Property, plant, and equipmentTrucks and Equipment $ 6,000Accumulated Depreciation (250) 5,750

Total Assets $ 114,590

LiabilitiesAccounts payable $ 12,000

Shareholder’s equityCommon shares $100,000Retained earnings 2,590 102,590

Total liabilities and shareholder’s equity $ 114,590

4

QUESTION 2 - Total of 17 Marks

Part A (12 marks)

Terry Ltd. (“Terry”) is looking for ways to improve its working capital position and reduce its reliance on external financing to fund operations. To that end, Terry is considering a change in its credit policy. Terry currently offers terms of 2/10, net 45 to its credit sales customers, which is more lenient than other companies in the same industry. Unfortunately, Terry has seen its bad debt costs increasing and sales volume has leveled off despite growth in the industry. Terry is considering changing its trade credit terms to be more in line with their competitors. The new credit terms would be 1/10, net 30.

The management at Terry has provided the following information:

1. Sales are expected to decrease by 5% from the current level of $26,000,000 annually. Variable costs on sales will remain at 40%. Assume all sales are on credit.

2. Terry currently has bad debts of 3.25% of sales. It is estimated that the new policy will decrease bad debts to 1.5% of sales.

3. Cost of goods sold is 35% of sales and Terry has an inventory turnover of 6.5, which is in line with industry standard. Terry expects to continue this inventory turnover rate even if the policy is changed.

4. Currently Terry has an average collection period of 50 days with 30% of customers taking the discount. With the change in credit terms it is estimated that 30% of customers will take advantage of the discount period, 25% will pay within 30 days, 25% will pay within 60 days and the remaining 20% will pay in 90 days.

5. The rate of return Terry expects from any investment in working capital is 5%.

Based on this information, should Terry change its credit terms?

See attached excel workbook for solution

Part B (3 marks)

How many days on average is Terry relying on external financing under the current policy? Assume that, on average, Terry has an accounts payable balance of $1,200,000.

Cash conversion cycle = days in inventory + days in receivables – days in payables

56 (365/6.5) + 50 (Part A) – 48 [365/[(9,100,000/1,200,000)] = 58 days

Part C (2 marks)5

Assuming Terry does not change its credit policy, what other things can Terry do to improve is cash position?

Negotiate extended credit terms with suppliers to pay later Charge interest and penalties for late payments from customers to encourage prompt

payment Other acceptable answers

QUESTION 3 – Total of 11 marks

Calculate the missing amounts for items (a) to (k). Show all your work.

A B C Sales $100,000 $239,000 $438,000Cost of goods sold (a) 122,000 345,000Inventory, beginning of year 23,000 45,000 (h)Inventory, end of year 17,000 39,000 105,000Average inventory (b) (e) 101,500Gross profit margin 46% (f) (i)Inventory turnover (c) (g) (j)Days in inventory (d) 126 (k)

A B C Sales $100,000 $239,000 $438,000Cost of goods sold 54,000 122,000 345,000Inventory, beginning of year 23,000 45,000 98,000Inventory, end of year 17,000 39,000 105,000Average inventory 20,000 42,000 101,500Gross profit margin 46% 49% 21%Inventory turnover 2.7 2.9 3.4Days in inventory 135 126 107(11 mark each)

6

QUESTION 4 – Total of 10 marks

Marrycroft Ltd. markets and distributes plastic yo-yo’s. The revenue per unit is $2.60 and the variable selling and distribution costs are $0.90 per unit. The fixed selling and administrative costs for this product amount to $250,000 and $90,000, respectively.

Required:

Consider each of the following questions separately:

a) What is the breakeven quantity in units? (2 marks)

a) If the company tax rate is 35%, what is the required revenue to earn a target after-tax profit of $125,000? (3 marks)

Pre-tax income = $125,000 / 0.65 = $192,308 (1 mark)CM Ratio = (1.70/2.60) = .6538 (1 mark)Revenue = ($340,000 + 192,308) / 0.6538 = $814,175 (1 mark)

b) If management estimates the margin of safety percentage as 20%, what is its expected level of sales in units? (3 marks)

Sales level – 0.20 × sales level = 200,000 (the break-even point)0.8 × sales level = 200,000Sales level = 200,000 / 0.8 = 250,000 units (3 marks)

c) Marrycroft is considering signing a contract to deliver 190,000 units of this product at a price of $2.40 per unit. Total fixed costs associated with this contract will be $297,000. Variable selling costs are expected to be $0.55 per unit. What is the maximum that Marrycroft would be willing to spend on shipping the product to the customer? (2 marks)

Profit before shipping costs (2.4 – 0.55) × 190,000 – 297,000 = $54,500Maximum that can be paid for shipping is $54,500. (2 marks)

7

CM/unit = $2.60 – 0.90 = $1.70Fixed costs = $250,000 + 90,000 = $340,000

Break-even quantity = $340,000 / 1.70 = 200,000 units (2 marks)

QUESTION 5 – Total of 15 marks

Donaldson Enterprises is the exclusive manufacturer of “Line Drive” baseballs. Presented below are the comparative balance sheets as at December 31, 2013 & 2014.

Additional information related to 2014:

Donaldson decided to upgrade its manufacturing equipment in 2014. On January 1st, the old manufacturing facility was sold for $375,000. The original cost of the equipment was $525,000 and the accumulated depreciation at the time of the sale was $125,000. The new equipment was also purchased on January 1st at a cost $575,000. The new equipment is being depreciated evenly over 10 years and there is no expected salvage value. There were no other acquisitions or disposals of any capital assets in 2014.

On December 31st, Donaldson declared and paid a cash dividend in the year of $1.50 per share.

Net income for 2014 was $229,000. On August 23rd, Donaldson issued 1,000 in common shares (fair market value =

$27,000) in full satisfaction of a note payable that had been entered into early in 2014.

8

AssetsCashAccounts ReceivablePrepaid Insurance

Part A (10 marks)

What is Donaldson’s cash flow from operating activities in 2014?

Net income $229,000

Add: Depreciation $62,500* (2)

Add: Loss on Equipment $25,000** (2)

Deduct: Increase to A/R $74,000

Deduct: Increase to Prepaid $ 2,700

Add: Decrease to Inventory $19,000

Add: Increase in AP $15,000

Deduct: Decrease in Unearned Rev $27,000

Cash from Operations $246,800

Part B (2 marks)

What is Donaldson’s cash flow from investing activities in 2014?

Proceeds from sale of Equipment $375,000

Purchase of new equipment ($575,000)

Cash from Investing Activities ($200,000)

Part B (3 marks)

What is Donaldson’s cash flow from financing activities in 2014?

Cash Settlement of Notes Payable ($14,000)***(2)

Dividends Paid ($16,500)****

Cash From Financing Activities ($30,500)

*($575,000/10 = $57,500) new equipment + $5,000 (building) = $62,500

**Proceeds on sale minus net book value = $375,000 – ($525,000-125,000) = $25,000 loss

*** Decrease in notes payable ($41,000) – amount settled with common shares ($27,000)

**** 1.50 x 11,000 shares outstanding

9

QUESTION 6 – Total of 30 marks

Appendix A contains the 2007 and 2008 Balance Sheet, Income Statement and Statement of Cash Flows for Ford Motor Company. Please fill out the table below and note that you can detach (“rip out”) Appendix A for easier analysis.

a) (16 marks) Calculate the following ratios for 2007 and 2008. 1 mark per ratio calculation (2 marks per year)

From the Selected General Motors Financial StatementsRatios to be calculated Year End 2008 Year End 2007

Debt to Total Assets = Total Liabilities/Total Assets

234,444/218,328 = 1.0738 272,215/279,264=0.9748

Cash to Total Debt Coverage: Cash provided by Operating Activities/Total Liabilities

(179)/234,444=-0.0008 17,074/272,215=0.0627

Inventory Turnover =COGS/Inventory

127,103/8618=14.74x 142,587/10,121=14.0x

Days in Inventory= 365 days/Inventory Turnover

365 days/14.74=24.76 days 365 days/14.0x=26 days

Receivables Turnover=Net credit Automotive Sales/accounts receivable

129,166/93484=1.3817 x 154,379/109053=1.4156x

Average Collection Period = 365 days/receivables turnover

365/1.3817=264 days 365/1.4156=257.8 days

10

Accounts Payable deferral period = COGS/Payables

127,103/14772=8.6x 142,587/20832=6.844

Days in Payables=365 days/Accts Payable Def. Period

365/8.6x=42.44 days 365/6.844=53.33 days

b) (4 marks) Using two ratios calculated in part a) comment on Ford's liquidity in 2008 as compared to 2007. Please identify the ratios that you are using as a reference. Do not exceed 4-5 sentences in your answer!

Cash to Total Debt Coverage using Total Liabilities Measures short-term debt paying ability (cash basis): negative in 2008 and very low for 2007 (2 marks)

Debt to Total Assets (2 marks)

c) (5 marks) Using the ratios calculated in part a) can you identify a problem with Ford's cash cycle? Please identify the ratios that you are using as a reference. Do not exceed 4-5 sentences in your answer!

Receivables Turnover -(1 mark)

Average Collection Period (1 mark)

Accts Payable Deferral Period - (1 mark)

Days in Payables (1 mark)

Ford pays their suppliers much more quickly than they are paid on their receivables. (1 mark)

d) (4 marks) In the notes to the financial statements, under Inventories (Note 8) the following appears:

11

Explain in your own words the 'LIFO' adjustment and its impact on inventory versus using FIFO for inventory valuation.

With LIFO the most recent inventory item is sold first therefore resulting in a lower ending value for inventory on the balance sheet (1 mark). Under FIFO, the ending inventory amount will be higher as the first items purchased in inventory are sold first (1 mark) - therefore the LIFO adjustment reconciles the inventory value using FIFO vs. LIFO. ( 2 marks)

12

Appendix A: Ford Motor Company

13

Appendix A: Ford Motor Company

14

Appendix A: Ford Motor Company

15