Financial Accounting: Liabilities & Equities (FA3) Exam Review

FA3 Exam Review notes Barbara Wyntjes, CGA, MBA, B.Sc. 

Financial Accounting: Liabilities & Equities (FA3) Exam 

Review 

Part 1: Module 1 – Accounting Polices and Analysis 

NOTES: I do NOT know what is on your exam. 

: Past exam questions are NOT updated to recent course material 

: See Past Exam Questions after each online lecture for different questions. 

3 hours = 1.8 minutes per mark Blueprint: 6-9% 

Question 1 Multiple Choice (30 marks) 2 marks each 

Select the best answer for each of the following unrelated items. Answer each of these 

items in your examination booklet by giving the number of your choice. For example, if 

(1) is the best answer for item (a), write (a)(1) in your examination booklet. If more than 

one answer is given for an item, that item will not be marked. Incorrect answers will be 

marked as zero. Marks will not be awarded for explanations. 

a. A company reports a decrease of $50,000 in accounts receivable and a decrease of 

$20,000 in unearned revenue. Sales reported on the income statement were $600,000. 

What is the total cash collected from customers? 

1) $530,000 

2) $570,000 

3) $630,000 

4) $670,000 

b. When vertical analysis is used to evaluate the balance sheet, what base amount is 

usually selected? 

1) Total assets 

2) Total liabilities 

3) Total shareholders’ equity 

4) Total revenues 

c. Sammy’s Sales Inc. has a current ratio of 2:1. This ratio will decrease if the company 

does which of the following? 

1) Borrows cash on a 6-month note 

2) Sells merchandise for more than cost and records the sale using the perpetual inventory 

method 

3) Receives a 5% stock dividend on one of its marketable securities 

4) Pays a large account payable that had been a current liability 

Multiple Choice solutions: 

a. 3 $600,000 + $50,000 – $20,000 = $630,000 

b. 1 

c. 1 

1


Question 2 

Kerri Martinsky, CEO of Polly Inc., has asked you, assistant controller, to compare the 

operations and financial position of Polly to those of its closest competitor, Plastic Ltd. 

Polly and Plastic are similar in size and overall business operations. The following 

information has been compiled for your review, based on the most recent financial 

statements: 

Common Size Income Statements 

Polly Inc. Plastic Ltd. 

2007 2006 2007 2006 

Sales $100.0 100 % $ 100 100% 

Cost of sales 72.0 70 68 70 

Gross margin 28.0 30 32 30 

Expenses 20.5 25 23 24 

Net income $ 7.5 5 % $ 9 6 % 

Increase in sales over 2006 30% 20% 

Polly Inc. Plastic Ltd. 

2007 2006 2007 2006 

Current ratio 2.05 1.80 1.57 2.16 

Quick ratio 0.87 0.53 0.42 0.66 

Accounts receivable turnover 20.00 16.67 11.61 10.00 

Inventory turnover 4.45 3.68 2.89 2.87 

Long-term debt to equity 0.08 0.17 0.47 0.58 

Return on total assets (ROA) 17.70 10.00 12.60 7.60 

Return on equity 28.90 16.00 26.20 15.20 

Investing activities 

Purchase of capital assets $10,000 $40,000 $250,000 $400,000 

You notice from the notes to the financial statements that both companies use similar 

accounting policies. 

Required 

7 a. Write a memo to Kerri that compares and contrasts Polly to Plastic in terms of: 

i) Liquidity, indicating which ratios you used in your analysis and which areas Kerri 

should be concerned with 

ii) Profitability, indicating which ratios you used in your analysis and which areas Kerri 

should be concerned with 

1 b. Indicate why Plastic’s long-term debt-to-equity ratio might be higher than Polly’s. 

2


Solution: 

a. (7 marks) 

To: Kerri Martinsky, CEO 

From: Zhang Chen, Assistant Controller 

Date: June 12, 2008 

Re: Ratio comparison with Plastic Ltd. 

(1) i) From a liquidity view, Polly appears to be quite liquid in 2007, compared with 

Plastic (quick ratio). 

(1) The receivables turnover and inventory turnover are significantly better than Plastic’s, 

indicating good management over this area. 

(1) This results in Polly having an overall better liquidity position than Plastic. There 

appears to be no concerns in this area; however, this is not to say improvements could not 

be made. 

(1) ii) From a profitability view, the return on assets and equity is very good, indicating 

that Polly is a well-managed and profitable business. 

(1) However, it should also be noted that Plastic is increasing its fixed assets and longterm 

debt, while Polly is not. Depending on the nature of these capital asset (for example, 

improved efficiency), this could cause concern in the future. 

(1) Also, Polly’s ROA is higher because it has a smaller asset base as a result of not 

investing in capital assets as much as Plastic has in the past 2 years. 

(1) We should investigate the decline of Polly’s gross margin, and attempt to reverse this 

trend. We should also reconsider Polly’s capital asset financing policy. The company has 

the capacity for additional long-term debt, which would provide leverage to further 

improve return on equity, and potential strategic advantages if invested in the correct 

assets. 

Note: 

3 marks for liquidity discussion; 3 marks for profitability discussion; 1 mark for areas of 

concern (lack of capital asset investment or gross margin decline) 

b. (1 mark) 

Plastic’s long-term debt is higher than Polly’s because Plastic is likely financing the 

purchase of capital assets with debt. 

3


Question 5 (9 marks) 

Information for MTC Limited follows: 

MTC LIMITED 

Comparative Balance Sheet 

2008 and 2007 

2008 2007 

Assets 

Cash $ 200,000 $ 500,000 

Accounts receivable 1,400,000 1,500,000 

Inventory 600,000 400,000 

Leased assets 3,250,000 3,250,000 

Accumulated amortization, leased assets (1,950,000) (1,700,000) 

Total $ 3,500,000 $ 3,950,000 

Liabilities and shareholders’ equity 

Accounts payable $ 320,000 $ 100,000 

Lease liability 2,100,000 2,550,000 

Bonds payable — 400,000 

Discount on bonds payable — (20,000) 

Preferred shares — 10,000 

Common shares 600,000 500,000 

Retained earnings 480,000 410,000 

Total $ 3,500,000 $ 3,950,000 

Additional information 

1. Preferred shares were converted to common shares during the year at their book value. 

2. Bonds payable were retired at the beginning of the year through an open market 

purchase at 101. As a result, MTC reported a loss on retirement of $24,000. 

3. Net income was $80,000. 

4. There was a common stock dividend valued at $4,000 and cash dividends were also 

paid. 

Required 

3 a. Prepare the operating activities section of the cash flow statement for the year ended 

December 31, 2008, using the indirect approach. 

6 b. Prepare the financing activities section of the cash flow statement for the year ended 

December 31, 2008. 

3 a. Operating activities 

Net income (given) $ 80,000 

(1) Add Amortization (1,700,000 + ? - 0 = 1,950,000) 250,000 

(1/2) Loss on bond repurchase (#2) 24,000 

(1/2) Decrease in accounts receivable 100,000 

(1/2) Increase in inventory (200,000) 

(1/2) Increase in accounts payable 220,000 

Cash provided by operating activities $ 474,000 

4


6 b. Financing activities 

(1) Bond repurchase (#2) $ (404,000) 

(1) Lease payment (2,550,000 – 2,100,000) (450,000) 

(2) Issuance of common shares (#4) 86,000 

(2) Cash dividends* (410,000 + 80,000 - 4,000 - ? = 480,000) (6,000) 

Cash used in financing activities $ (774,000) 

*IFRS: Under operating or financing activities 

First deal with Additional Information: 

1. Preferred share 10,000 (change on balance sheet) 

Common shares 10,000 

Non cash thus not stated on cash flow statement 

2. Bond payable 400,000 

Loss (to balance) 24,000 

Cash (101% x 400,000) 404,000 

Discount on BP 20,000 

3. Net income 80,000 

4. Change in Common shares 500,000 bgn + 10,000 (#1) + 4,000 (#4) + ? = 600,000 

end. Thus must have issued 86,000 of C/S in 2008 to have an ending balance of 600,000 

Part 2: Module 2 - Liabilities 

Blueprint: 10-13% 

a. Suzette’s Saxophones Inc. (SS) borrowed US$200,000 on January 2, 2003, when the 

exchange rate was US$1 = C$1.50. The exchange rate at December 31, 2003 was $1.48. 

The average exchange rate during 2003 was $1.49. On December 31, 2003, which of the 

following will be one of SS’s adjusting entries? 

1) A foreign exchange loss of $2,000 

2) A foreign exchange loss of $4,000 

3) A foreign exchange gain of $2,000 

4) A foreign exchange gain of $4,000 

b. Which of the following lists indicates the proper order for reporting current liabilities? 

1) Bank loan; accounts payable; warranty liability; unearned rent revenue 

2) Bank loan; accounts payable, unearned rent revenue; warranty liability 

3) Bank loan; unearned rent revenue; accounts payable; warranty liability 

4) Bank loan; warranty liability; accounts payable; unearned rent revenue 


a. 4) [$200,000 × ($1.50 – $1.48)] = $4,000 

b. 1 (see text page 719) 

5



Zara’s Painting Supplies Ltd. entered into a non-cancellable contract with Paint Factory 

Inc. to purchase 10,000 litres of paint at $20 per litre (total contract price $200,000). The 

contract was signed on September 28, 2003. The paint was delivered on January 15, 

2004. Paint Factory sells all of its product on 30-day terms. 

At December 31, 2003, the market price of the paint was $18 per litre. When the paint 

was delivered on January 15, 2004, the market price was still $18 per litre. 

Required: Prepare all required journal entries for Zara’s Painting Supplies as at 

September 28, 2003; December 31, 2003; and January 15, 2004. If a journal entry is not 

required for a particular date, write ―No Entry Necessary‖ and briefly explain why. 

September 28, 2003 

1 No entry necessary. Commitments are not normally recorded in the accounting system. 

December 31, 2003 

1 Estimated loss on purchase commitment [10,000 litres ($18 – $20)] ...... 20,000 

1 Estimated liability on non-cancellable purchase commitment ......................20,000 

January 15, 2004 

1 Inventory (paint)...................................................................... 180,000 

1 Estimated liability on non-cancellable purchase commitment ........ 20,000 

1 Accounts payable ........................................................................................200,000 


On November 1, 2002, Zoë Ltd. issued $1,000,000 of 10% bonds payable to yield 8%. 

Bond issue costs of $36,000 were paid and recorded in a separate ledger account. The 

bonds were 10-year bonds dated May 1, 2002. Interest is payable semi-annually on April 

30 and October 31. The bond issue costs are amortized on a straight-line basis. The bond 

discount or premium is amortized using the effective rate method. Zoë, which has a 

December 31 year end, does not make any adjusting entries throughout the year. 

Required 

3.5 a. Calculate the issue price of the bonds and record the required journal entry(ies) to 

reflect the issuance of the bonds and payment of the bond issue costs. 

2.5 b. Prepare the adjusting journal entry(ies) that would be required on December 31, 

2002. 

7 c. On February 28, 2003, $500,000 par value of the bonds were retired at 102 plus 

accrued interest. Prepare the required journal entry(ies). 

6


a. FV = $1,000,000, i = 8/2 = 4%, n = 19, PMT = 50,000, PV of bond $ 1,131,295 (1) 

November 1, 2002 

(1/2) Cash...................................................................................... 1,131,295 

(1/2) Premium on bonds payable............................................................131,295 

(1/2) Bonds payable ........................................................................... 1,000,000 

(1/2) Bond issue costs ....................................................................... 36,000 

(1/2) Cash..................................................................................................36,000 

b. December 31, 2002 

(1/2) Interest expense ($1,131,295 × 8% × 2/12)..................................... 15,084 

(1/2) Premium on bonds payable ($16,667 – $15,084) ............................ 1,583 

(1/2) Accrued interest payable ($1,000,000 × 10% × 2/12) ........................... 16,667 

(1/2) Interest expense ..................................................................................... 632 

(1/2) Bond issue costs ($36,000 × 2/114) 1 ..........................................................632 

1 The 10-year bond will be outstanding for 114 months 

(10 years × 12 months, less 6 months in 2002 unissued). 

c. February 28, 2003 

(1/2) Interest expense ($1,131,295 × 8% × 2/12) × 50% ................. 7,542 

(1/2) Premium on bonds payable ($8,334 – $7,542).......................... 792 

(1/2) Accrued interest payable ($1,000,000 × 10% × 2/12) × 50%.................8,334 

(1/2) Interest expense ......................................................................................316 

(1/2) Bond issue costs ($36,000 × 2/114) × 50% .............................................. 316 

(1/2) Bonds payable ............................................................... 500,000 

(1/2) Accrued interest payable (16,667 × 50% + 8,334) ......... 16,667 

(1) Premium on bonds payable [($131,295 – $1,583) × 50% – $792].. 64,064 

(1) Gain on bond retirement ........................................................................36,696 

(1/2) Bond issue costs ($36,000 × 50% × 110 / 114) .....................................17,368* 

(1) Cash [($500,000 × 102%) + ($500,000 × 10% × 4/12)]...................... 526,667 

*(36,000 – 632) x 50% = 17,684 – 316 = 17,368 

Note: For part c), the entries for interest expense, accrued interest payable, and premium 

on bonds payable may be combined. 

7


Part 3: Module 3 – Shareholders’ Equity 


a. JMN Company had opening retained earnings of $100,000. Net income for the year 

was $23,000. During the current year, an error in the prior year was discovered resulting 

in a credit to retained earnings for $5,000, and 1,000 shares were retired at $2 above their 

book value. There was no contributed capital account prior to the retirement of the shares. 

Ending retained earnings was $102,000. What was the amount of dividend declared for 

the year? 

1) $14,000 

2) $24,000 

3) $26,000 

4) $28,000 

b. When a property dividend is declared, the book value of the property and the market 

value are not the same. How should the dividend be recorded? 

1) It should be recorded at the book value of the property at the date of declaration. 

2) It should be recorded at the market value of the property at the date of declaration. 

3) It should be recorded at the market value of the property at the date of distribution. 

4) It should be recorded at the book value or market value, whichever is higher at the date 

of declaration. 

c. What is a dividend called when a portion of the shareholders’ original investment is 

returned? 

1) Equity dividend 

2) Special dividend 

3) Liquidating dividend 

4) Compensating dividend 

d. Which of the following type of dividends does not reduce retained earnings? 

1) Cash dividend 

2) Stock dividend 

3) Property dividend 

4) Liquidating dividend 

e. DKM Co. previously issued cumulative non-convertible preferred shares with an 

annual dividend payable on December 31. Dividends were last paid on December 31, 

2002, and no dividends were declared in 2005. In DKM’s December 31, 2005 financial 

statements, how will DKM report these dividends in arrears? 

1) Subtract 3 years of dividends on preferred shares from earnings when computing 2005 

basic earnings per share 

2) Report a liability equal to 2 years of dividends on the preferred shares 

3) Disclose in a footnote that the dividends on preferred shares are 2 years in arrears 

4) Disclose in a footnote that the dividends on preferred shares are 3 years in arrears 

8


f. On July 1, 2006, XZC Co. issued (sold) 2,000 of its no-par-value common shares and 

4,000 of its no-par-value convertible preferred shares for a lump sum of $60,000. At the 

date of issue, XZC’s common shares were trading at $17 per share and the convertible 

preferred shares at $7 per share. What should the amount of the proceeds allocated to 

XZC’s common share account be? 

1) $32,000 

2) $32,903 

3) $34,000 

4) $35,133 


a. 2 [100,000 + 23,000 + 5,000 – (1,000 × 2) – 102,000] = $24,000 

b. 2 

c. 3 

d. 4) 

e. 4) 

f. 2) (2,000 × $17) = 34,000, (4,000 x $7) = 28,000. Total $62,000 

(34,000/62,000) x $60,000 = $32,903 

Part 4: Module 4 – Complex Debt and Equity Instruments 


a. XQL Inc. sells $1,000,000 of 6%, 5-year bonds with detachable share purchase 

warrants for $1,040,000. Each $1,000 bond carries a warrant that entitles the investor to 

purchase 1 common share for $200. Shortly after the issuance, the warrants trade for $50 

each and the bonds are quoted at 103 ex-warrants. Assuming that XQL used the 

proportional method to record this transaction, what was the net amount allocated to the 

bonds? 

1) $ 950,000 

2) $ 990,000 

3) $ 991,850 

4) $1,000,000 

b. Zil Co. has $4,000,000 of 8% convertible bonds outstanding. Each $1,000 bond is 

convertible into 30 no-par-value common shares. The bonds pay interest on January 31 

and July 31. On July 31, 2006, the holders of $3,000,000 of the bonds exercised the 

conversion privilege (converted their bonds into common shares). At the conversion date, 

the market price of the bonds was $1,050 each, the market price of the common shares 

was $36 each, and the balance in the contributed capital, common stock conversion rights 

account was $120,000. 

9


If Zil uses the book value method to record the conversion, what will the journal entry 

include? 

1) A $90,000 debit to contributed capital, common stock conversion rights 

2) A $120,000 debit to contributed capital, common stock conversion rights 

3) A loss on bond redemption of $150,000 

4) A loss on bond redemption of $180,000 


a. 3 [$1,030 / ($1,030 + $50)] $1,040 = $991,850 

b. 1 120,000 x .75 = 90,000 


Tom’s Tequila Inc. (TT) sold $1,000,000 of 9%, 10-year convertible bonds on January 1, 

2002 for proceeds of $960,000. The market was demanding a 10% yield for similar bonds 

that did not have a conversion privilege. At the investor’s option, each $1,000 bond is 

convertible into 25 common shares until December 31, 2007, and into 30 common shares 

from January 1, 2008, until maturity. The bonds are dated January 1, 2002, and pay 

interest annually on December 31, maturing December 31, 2011. TT uses the effective 

interest method to amortize discounts or premiums, and the book value method for 

conversion. 

On January 1, 2003, 70% of the bonds were converted. At that time, the common shares 

were trading at $55. The rest of the bonds were never converted. 

TT is a public company listed on the Toronto Stock Exchange. 

Required: Note that the bonds are convertible at the investor’s option. 

Prepare journal entries for January 1, 2002; December 31, 2002; January 1, 2003; and 


Using factor tables: $ 938,514 

Value of conversion rights ($960,000 – $938,514) = $21,486 (Incremental method) 

Note: A financial calculator may also be used. Answers determined with the calculator 

may vary slightly due to rounding. FV = 1,000,000, n = 10, i = 10, PMT = 90,000, PV = 

938,554 

10



(1) Cash............................................................................................. 960,000 

(1) Discount on bonds payable ($1,000,000 – $938,514) .................. 61,486 

(1) Contributed capital - conversion rights ............................ 21,486 

(1) Bonds payable ........................................................................................... 1,000,000 


(1) Interest expense ($938,514 x 0.10) ................................................ 93,851 

(1) Discount on bonds payable............................................................................ 3,851 

(1) Cash ($1,000,000 × 0.09) .............................................................................. 90,000 


(1) Contributed capital - conversion rights ($21,486x0.70) .... 15,040 

(1) Bonds payable ($1,000,000x 0.70)................................................... 700,000 

(1) Discount on bonds payable [($61,486 – $3,851) 0.70]............................... 40,345 

(1) Common shares ($700,000 – $40,345 + $15,040)....................................... 674,695 


(1) Interest expense ($297,276x 0.10) ........................................... 29,728 1 

(1) Discount on bonds payable............................................................................ 2,728 

(1) Cash ($300,000x 0.09) ................................................................................. 27,000 2 

(1) Cont. capital - conversion rights (21,486–15,040) ..... 6,446 

(1) Contributed capital, lapse of conversion rights............................................. 6,446 

(1) Bonds payable .......................................................................................300,000 

(1) Cash..............................................................................................................300,000 2 

1 PV of the bond ($300,000) and interest ($27,000) = $327,000 

$327,000 xP/F, 10%, 1 = $327,000x 0.9091 = $297,276 

2 May be combined 

11


Part 5: Module 4 continued 


On January 1, 2000, SVO Ltd. granted stock options to its chief executive officer (CEO). 

This is the only stock option plan that SVO offers. The details of the stock options are set 

out below: 

Option to purchase 5,000 no-par-value common shares 

Option price per share $62.00 

Market price per share at grant date $57.00 

Stock options expire The earlier of 8 years after issuance or the 

employee’s cessation of employment with the 

company for any reason other than retirement. 

The options are first exercisable The earlier of 4 years after issuance or the date on 

which an employee reaches the retirement age of 

65. 

Fair value at grant date is$10.00. On January 1, 2005, 4,000 of the options were exercised 

when the market price of the common shares was $78.00. The rest of the options were 

allowed to expire. 

Required 

8 a. Record the required journal entries for the following dates: 

(1) i) January 1, 2000 (issue date) 

(2) ii) December 31, 2000 (year-end) 

(3) iii) January 1, 2005 (exercise date) 

(2) iv) December 31, 2007 (the expiry date of the options) 

3 b. Record the required note disclosure on financial reporting for the stock option plan at 


Extra: Assuming SVO uses the indirect method for preparing the statement of cash 

flows, state the required disclosure in this statement. 

8 a. 

(1) i) Jan. 1, 2000 (the grant date): Memo entry, describing the options and their terms 

(2) ii) December 31, 2000 

(1) Compensation expense (5,000 × $10 / 4 years) ................................12,500 

(1) Contributed capital — common share options.................................12,500 

(To record the grant of stock options to the CEO) 

(3) iii) January 1, 2005 

(1) Cash (4,000 × $62) ................................................................ 248,000 

(1) Contributed capital — common share options 

(4,000 / 5,000 × $50,000 1 )............................................................ 40,000 

(1) Common shares ............................................................................ 288,000 

(To record the exercise of stock options to the CEO) 

1 (5,000 × $10.00 or $12,500 per year × 4 years = $50,000) 

12


(2) iv) December 31, 2007 

(1) Contributed capital — common share options.......................... 10,000 

(1) Contributed capital — lapse of common share options ................. 10,000 

(To record the expiration of stock options granted to the CEO) 

3 b. On January 1, 2000, SVO granted stock options to the CEO for the purchase of 5,000 

of the company’s no-par-value common shares at $62 each. 

The options expire on December 31, 2007. 

Options are exercisable the earlier of 4 years after issuance (January 1, 2004) or the date 

on which the employee reaches the retirement age of 65. 

The value of each option at grant date, as determined by using a binomial pricing model, 

was $10.00. 

$12,500 was charged to compensation expense for the year ended December 31, 2000. 

No options are currently exercisable under this plan, which is the only one that SVO 

offers. 

No options were exercised or lapsed during the year. 

Note: 1 mark each to a maximum of 3 marks 

Extra: 

Indirect method of presentation: 2000-2003 

i) Cash flows from operating activities 

Net income $ xxx 

Add: Compensation expense — stock options 12,500 (non-cash) 

In 2005: Cash flows from financing activities 

Add: Issuance of common shares for cash $ 248,000 

Part 6: Module 5 – Leases 


a. What is the difference between a direct financing lease and a sales-type lease for 

lessors? 

1) For a direct financing lease, collection is not reasonably assured. 

2) For a direct financing lease, there are significant costs that are difficult to estimate. 

3) For a direct financing lease, the lease does not meet any of the capitalization criteria 

for a capital lease. 

4) For a direct financing lease, the lessor earns only interest revenue on the lease 

arrangement. 

NOTE: IFRS terminology is different: direct financing = financing company; salestype 

= manufacturer/dealer 

Multiple Choice solution: a. 4 

13



Fred’s Fabricating Ltd., which has a December 31 year end, offers lease financing to 

customers who want to buy its prefabricated buildings. Fred’s Fabricating has just 

completed a building at a cost of $3,000,000 and will lease it on July 1, 2003, to Bill’s 

Building Corp., a manufacturing company. Fred’s Fabricating’s mark up on the building 

is 30% of cost. 

• The lease term is 15 years; the building’s estimated useful life is 22 years. 

• The building’s residual value at the end of the lease term is estimated to be $500,000. 

This value is not guaranteed. The salvage value is estimated to be $100,000. Terms of 

the lease allow Bill’s Building the option of purchasing the building at the end of the 

lease term for $200,000. 

• Bill’s Building’s incremental borrowing rate is 9%. 

• Bill’s Building knows that the interest rate implicit in the lease is 8%. 

• The first annual lease payment is due July 1, 2003. 

Required 

2 a. Calculate the required annual lease payments. 

8 b. Prepare all required journal entries for the lessee, Bill’s Building Corp., for the year 

2003. 

3 c. Accounting standards sets out the classification criteria that the lessee must use to 

determine if a lease qualifies as a capital lease for financial reporting purposes. 

Essentially, the 4 criteria are 

• a transfer of ownership at the end of the lease term or a bargain purchase 

option; 

• the lease term major/ ≥ 75% of economic life; or 

• the present value of the minimum lease payments substantially all/ ≥ 90% of 

fair market value. 

• IFRS: specialized nature of asset 

In addition to the foregoing, the lessor is required to use supplemental criteria. Identify 

the supplemental criteria used by the lessor and explain briefly (in one or two sentences) 

why these additional requirements are necessary. 

Solution: There is a bargain purchase option (option to purchase at $200,000 versus an 

estimated value at the end of the lease term of $500,000). Accordingly, this is a 

capital/financing lease as there is reasonable assurance that the lessee will obtain 

ownership of the leased property by the end of the lease. 

a. Selling price ($3,000,000 × 1.30) $3,900,000 

BGN, PV = 3,900,000, n = 15, i = 8, FV = 200,000, PMT = ? = 415,064 (tables 415,067) 

b. July 1, 2003 

(1) Asset under capital/financing lease ................................3,900,000 

(1) Lease liability ............................................................ 3,900,000 

14


(1) Lease liability ........................................................ 415,067 

(1) Cash.................................................................................................... 415,067 


(1) Interest expense [($3,900,000 – $415,067) × 0.08 × 6/12] ............ 139,397 

(1) Accrued interest payable .................................................................... 139,397 

(1) Amortization expense {[($3,900,000 – $100,000) / 22] × 6/12}.. 86,364 

(1) Accumulated amortization.................................................................. 86,364 

c. 

(1) • The credit risk associated with the lease is normal when compared with the risk of 

collection of similar receivables. 

(1) • The amounts of any non-reimbursable costs that are likely to be incurred by the 

lessor under the lease can be reasonably estimated. 

(1) • The profession wants to make sure that the lessor has really transferred the risks and 

rewards of ownership. 

Part 7: Module 6 – Accounting for Income Tax 


a. Which of the following is true about intraperiod tax allocation? 

1) It involves the allocation of income taxes between current and future periods. 

2) It arises because items included in the determination of taxable income may be 

presented in different parts of the financial statements. 

3) It arises because certain revenues and expenses appear in the financial statements 

either before or after they are included in the income tax return. 

4) It is more directly related to the full disclosure principle than the matching principle. 

b. In 2006, DTY Inc. made an investment of $200,000 that qualifies for a 7% investment 

tax credit. How should DTY record the benefit of the investment tax credit? 

1) As a decrease in tax expense for 2006 

2) As a direct increase to retained earnings 

3) As an increase in a deferred charge 

4) As a reduction in the cost of the investment 


a. 2 

b. 4 

15



Lion Ltd. is about to prepare its financial statements for the year ended December 31, 

2004. Pertinent information follows: 

• In 2004, amortization was $270,000 and CCA was $135,000. At the beginning 

of the year, the net book value of capital assets was $2,000,000, while the UCC 

was $1,500,000. 

• Accounting income before income taxes was $1,000,000. 

• The company had $50,000 in entertainment expenses, which were included in 

the income statement. Only 50% of this amount is deductible for tax purposes. 

• The company received rent in advance of $75,000. This amount is taxable but 

has not been included in its income statement. 

• In March 2004, the income tax rate for 2004 and later years increased to 35%. 

This was not expected since the income tax rate had been 30% since 2000. The intended 

change was enacted into law in November 2004. 

Required 

11 a. Assume that Lion is a public company. Reconcile ―Accounting income before 

income taxes‖ to ―Taxable income,‖ and prepare the required income tax related journal 

entries for 2004. 

2 b. Prepare the bottom section of the income statement, beginning with income before 

income taxes. 

11 a. Income taxes payable 

(1/2) Accounting income before income taxes $ 1,000,000 

Permanent differences 

(1/2) 50% entertainment expenses 25,000 

Temporary differences 

(1/2) Rent received in advance 75,000 

(1/2) CCA (135,000) 

(1/2) Amortization/depreciation 270,000 

(1/2) Taxable income $ 1,235,000 

Income tax payable @ 35% $ 432,250 

Journal entry: 

(2) Income tax expense (432,250 – 26,250 – 22,250) ....................... 383,750 

(2) Deferred/Future income tax asset - rent revenue ......................... 26,250 

(2) Deferred/Future income tax liability - capital assets ... 22,250 

(2) Income taxes payable....................................................................... 432,250 

2 b. Income statement 

(1/2) Income before income taxes $ 1,000,000 

(1/2) Income tax expense — current $ 432,250 

(1/2) — Deferred/future (48,500) 383,750 

(1/2) Net income $ 616,250 

Effective tax rate: 383,750/1,000,000 = 38.375% 

16


The following table and reconciliation are not required for marks. 

B/S I/S 

2004 Tax Basis Accounting Temporary Defer/Future Opening Adjustment 

dr (cr) Basis Difference Tax Asset Balance for Current 

dr (cr) deductible (liability) dr (cr) Year 

(taxable) @ 35% dr (cr) 

Rent 

Revenue 75,000 0 75,000 26,250 0 26,250 

Capital 

Assets 1,365,000 1 1,730,000 2 

(365,000) (127,750) (150,000) 3 

1 

$1,500,000 – $135,000 = $1,365,000 

2 

$2,000,000 – $270,000 = $1,730,000 

3 

($1,500,000 – $2,000,000) x 0.30 = $150,000 beginning balance already on BS 

Part 8: Module 7 – Pension Costs and Obligations 


22,250 

a. A company’s pension plan assets equal its accrued benefit obligation. If the company’s 

balance sheet indicates a pension liability, which of the following must be true about the 

company’s pension plan? 

1) There are unrecognized past services costs. 

2) There are unamortized actuarial losses. 

3) There are unamortized actuarial gains. 

4) The company’s balance sheet is incorrect; there should be no asset or liability reported 

for pensions. 

b. MJU’s pension plan had the following balances at the beginning of 2006: 

Plan assets $ 800,000 

Projected benefit obligation 940,000 

Unamortized past service costs 80,000 

Unamortized actuarial gain 120,000 

Assume MJU uses the corridor method for calculating pension expense. The average 

remaining service period (ARSP) is 10 years and the period of vesting* is 8 years. What 

amount of the actuarial gain should be included in the calculation of pension expense for 

2006? 

1) $2,600 

2) $3,250 

3) $4,000 

4) $5,000 

* PEQs may state expected period to full eligibility 


a. 3 

b. 1 940,000 x .10 = 94,000 – 120,000 = 26,000/10 = 2,600 

17



On January 1, 2003, Rhonda’s Roofing Inc. (RR), improved the non-contributory defined 

benefit pension plan for its employees. An actuary has indicated that the amendment 

resulted in past service costs (PSC) of $1,200,000. The employees’ period to vesting and 

expected average remaining service life is both 8 years. 

On July 1, 2003, the actuary advised you that the projected benefit obligation increased 

$75,000 as a result of a change in the assumptions used. 

Other details of note in 2003 are as follows: 

• Employer’s contribution (paid to the pension trustee) at the end of the year $400,000 

• Current service cost $150,000 

• Deferred pension liability as at January 1, 2003 $300,000 

• Accrued benefit obligation at the beginning of the year (excluding the PSC) $800,000 

• Plan assets at the beginning of the year $500,000 

• Benefits paid out during 2003 $100,000 

• Expected return on plan assets 11% 

• Actual return on plan assets $60,000 

• The actuarial interest rate 10% 

Required 

4 a. Calculate the pension expense recognized in 2003. 

2 b. Calculate the accrued benefit obligation as at December 31, 2003. 

4 c. Prepare the journal entries to reflect RR’s accounting for the pension plan for 2003. 

6 d. Pension legislation currently permits three different methods of funding defined 

benefit pension plans. Identify the three methods and briefly describe each. 

Note: the table is not required for marks. 

Deferred Accrued Unamortized 

Date and Pension Pension Benefit Plan Unamortized Actuarial 

Details exp. Cash Asset/Liab Obligation Asset PSC Loss 

12/31/02 $ $ $300,000C $800,000C $500,000D $ $ 

01/01/03 1,200,000C 1,200,000D 

01/01/03 300,000C 2,000,000C 500,000D 1,200,000D 

Actuarial loss 75,000C 75,000D 

Service cost 150,000D 150,000C 

Interest 200,000D 200,000C 

Exp Return 55,000C 55,000D 

Actual ret. 60,000D 60,000C 

Amortize PSC 150,000D 150,000C 

Pension payments 100,000D 100,000C 

12/31/03 400,000C 400,000D 

445,000D 400,000C 45,000C 

$345,000C $2,325,000C $860,000D $1,050,000D $70,000D 

Next year amortization of net actuarial gain/loss? $70,000 < ($2,325,000 x 10%) thus no 

18


4 a. 

(1) Current service cost $ 150,000 

(1) Interest on accrued benefit obligation [(800,000 + 1,200,000) × 10%] 200,000 

(1) Expected return on plan assets ($500,000 × 0.11) (55,000) 

(1) Amortization of past service cost ($1,200,000 / 8) 150,000 

Pension expense $ 445,000 

2 b. Accrued benefit obligation as at December 31, 2002 (as per above) $ 2,325,000 

4 c. December 31, 2003 

(1) Pension expense ........................................................ 445,000 

(1) Deferred pension asset.................................................. 445,000 1 

(1) Deferred pension asset ............................................ 400,000 1 

(1) Cash..... ........................................................................................... 400,000 

1 May be combined into one entry 

6 d. 

(2) The accumulated benefit method calculates the contribution that an employer must 

make in order to fund the pension to which the employee is currently entitled, based on 

the years of service to date and on their current salary. 

(2) The projected benefit/unit credit method calculates the required funding based on the 

years of service to date but on a projected estimate of the employee’s salary at the 

retirement date. 

(2) The level contribution method projects both the final salary and the total years of 

service and then allocates the cost evenly over the years of service. 

Part 9: Module 8 – Accounting Changes 


NOTE: Assume IFRS 

a. Frank Inc. purchased equipment on January 1, 2000 for $100,000. The company 

estimated that the equipment had a 5-year useful life and no salvage value. Frank 

amortized the equipment using the straight-line method for 4 years. During 2004, Frank 

re-estimated the total useful life of the equipment to be 8 years. What is the amount of the 

amortization expense in 2004? 

1) $ 2,500 

2) $ 5,000 

3) $ 8,000 

4) $ 12,500 

19


b. Based on an annual review, CDF Company changed its amortization policy from 

straight line to declining balance. How should this change in policy be applied, assuming 

that CDF has all of the information required to make the change? 

1) Prospectively 

2) Retrospectively without restatement 

3) Retrospectively with restatement 

4) This change should not be allowed 

c. Maluk Mining Ltd. spent $3,000,000 developing a silver mine. The $3,000,000 in 

development costs was debited to an asset account ―Natural resources — Silver Mine‖. 

Maluk estimated that the mine would yield 10,000,000 ounces of silver. Maluk 

commenced operations in 2002. During 2002, 2,000,000 ounces of silver were mined. 

Early in 2003, a new vein of ore was discovered that contained an estimated additional 

4,000,000 ounces of silver. During 2003, 3,000,000 ounces of silver were mined. What is 

the amount of depletion expense in 2003? 

1) $471,429 

2) $600,000 

3) $642,857 

4) $900,000 

j. KYM Corporation discovered an error in its record keeping from the previous year. 

Utilities for the month of December were recorded as $2,600 instead of the correct 

amount of $6,200. Which of the following journal entries would be made to correct the 

error in the current year? Ignore taxes. 

1) Utilities expense .................................................................................3,600 

Utilities payable .................................................................................. 3,600 

2) Retained earnings .............................................................................. 3,600 

Utilities payable .................................................................................. 3,600 

3) Utilities payable ..................................................................................3,600 

Retained earnings ................................................................................ 3,600 

4) Utilities payable ..................................................................................3,600 

Utilities expense .................................................................................. 3,600 


a. 2 $100,000 – $100,000 (4/5) = $20,000; $20,000 / 4 = $5,000 

b. 1 

c. 2 

3,000,000 × $0.20 1 = $600,000 

1 Depletion rate in 2002 $3,000,000/10,000,000 ounces = $0.30 per ounce 

Depletion base in 2003 $3,000,000 – $600,000 2 = $2,400,000 

10,000,000 ounces – 2,000,000 ounces + 4,000,000 ounces = 12,000,000 ounces 

Depletion rate in 2003 $2,400,000/12,000,000 ounces = $0.20 per ounce 

2 2,000,000 × $0.30 

j. 2 

20



JD Limited has used the average cost (AC) method to determine inventory values since 

its inception. In 2008, the company decided to switch to the first-in, first-out (FIFO) 

method to conform to industry practice. The income tax rate is 40%. Assume any tax 

difference due to change in inventory valuation policy is a temporary difference. The 

following information is available: 

2006 2007 2008 

Ending inventory, AC method $ 15,000 $ 24,000 $ 23,000 

Ending inventory, FIFO method 26,000 30,000 28,000 

Net income, AC method 60,000 62,000 55,000 

Opening RE, AC method 170,000 180,000 230,000 

JD has a December 31 year end. 

Required 

2 a. Briefly explain how the change in inventory policy should be reported for the 2008 

financial statements. 

6 b. Calculate net income, using the FIFO method, for 2007 and 2008 

2 a. 

Retrospective application with restatement of prior periods is required since information 

is available to recalculate comparative figures for the 2008 financial statements. 

6 b. 

2007 net income 

Original $ 62,000 

(2) Change in beg. inventory, net of tax (26,000 – 15,000) (1 – 0.40) (6,600) 

(1) Change in end. inventory, net of tax (30,000 – 24,000) (1 – 0.40) 3,600 

2007 net income (FIFO) $ 59,000 

2008 net income 

Original $ 55,000 

(1) Change in beg. inventory, net of tax (30,000 – 24,000) (1 – 0.40) (3,600) 

(2) Change in ending inventory, net of tax (28,000 – 23,000) (1 – 0.40) 3,000 

2008 net income (FIFO) $ 54,400 

21


Part 10: Module 9 –Earnings per share 


a. At December 31, 2003, Bob Co. has share options outstanding that permit the holders 

to acquire a total of 100,000 common shares at a price of $20 per share. The options can 

be exercised at any time between January 1, 2005 and December 31, 2008, at which latter 

time they expire. The average common share price during 2003 was $30, and the yearend 

price was $25. Because of the options, how would the denominator of the diluted 

EPS change in the December 31, 2003 financial statements? 

1) No change as the options are not yet exercisable 

2) Increase by 20,000 shares 



a. 3 100,000 x $20 = $2,000,000; $2,000,000 / $30 = 66,667; 100,000 issue – 66,667 

retired = 33,333 net increase 


Below is information from the December 31, 2006 balance sheet for NG Co. 

Bonds payable — $500,000 par value, 7%, maturing December 31, 

2015, each $1,000 bond is convertible into 30 common shares at the 

holder’s option (net) $ 450,000 

Preferred shares — $2, no par value, cumulative, convertible 

at 1 preferred share for 2 common shares - 14,000 shares outstanding 210,000 

Contributed capital — common share options outstanding 70,000 

Common stock conversion rights — 7% bonds 30,000 

Common shares — no-par value, 320,000 shares outstanding 800,000 

Additional information 

1. There are no dividends in arrears at the beginning of the year. No dividends have been 

declared for 2006. 

2. Net income for 2006 is $1,263,000; includes $38,000 interest expense for the 7% 

bonds. 

3. Income tax rate is 40%. 

4. Bonds, options, and preferred shares were outstanding for the entire year. 

5. The stock options are noncompensatory and are convertible into a total of 80,000 

common shares at an exercise price of $32.30. The average share price during the year 

was $34. 

6. No other common share transactions occurred during the year. 

Required 

10 a. Calculate basic and diluted earnings per share (EPS) for the year ended December 

31, 2006. 

3 b. Assume that one-half of the stock options were exercised on January 1, 2007. 

Prepare the journal entry(ies) to record the exercise of stock options. 

22


10 a. 

Basic EPS Basic EPS 

Net income $ 1,263,000 

(1) Preferred dividends (14,000 × 2) (28,000) 

Net income available to common shareholders $ 1,235,000 

(1) Weighted average common shares outstanding 320,000 $3.86 

(3) Individual calculations: 

Net Income Shares EPS 

7% Bonds 

[38,000 × (1 – 0.4)] $ 22,800 

(500,000 / 1,000 × 30) 15,000 1.52 

Preferred shares 28,000 

(14,000 × 2) 28,000 1.00 

Options: Cash = (80,000 × $32.30) = $2,584,000/$34 = 76,000 buy back. 

80,000 issue – 76,000 retired = 4,000 net increase in new shares. 

Diluted EPS 

Basic $ 1,235,000 320,000 $ 3.86 

Options 

(1.5) Shares issued 4,000 

(1/2) 1,235,000 324,000 3.81 

(1) Preferred shares 28,000 28,000 

(1/2) 1,263,000 352,000 3.59 

(1) Bonds 22,800 15,000 

(1/2) Diluted EPS $ 1,285,800 367,000 $ 3.50 

Note: 1.5 marks for determining order of dilution 

3 b. 

(1) Cash (80,000 × 1/2 × 32.30)..................................................1,292,000 

(1) Contributed capital — Options (70,000 × 1/2)...........................35,000 

(1) Common shares ..................................................................... 1,327,000 

23


Part 11: Module 10 – Partnership Equity Accounting 


a. Bob and Zarai invited Helen, a CGA, to join their partnership. Helen will be required 

to invest $120,000 in the partnership. This contribution will entitle her to a 25% 

ownership interest. Assuming that Bob’s capital balance is $80,000 and that Zarai’s 

balance is $100,000, what will Helen’s opening balance in her capital account be? 

1) $ 45,000 

2) $ 75,000 

3) $100,000 

4) $120,000 

b. DEF partnership is formed on January 1, 2004. Partners D, E, and F contribute cash of 

$20,000, $30,000, and $150,000 respectively. The partners agree on a profit and loss 

sharing ratio of 1:1.5:7.5. 

During the first year, net income is $180,000 and the partners’ drawings are D: $20,000, 

E: $20,000, and F: $70,000. What is partner E’s capital balance as at December 31, 2004? 

1) $ 18,000 

2) $ 37,000 

3) $ 70,000 

4) $ 215,000 

c. Which of the following views best describes the nature of ownership in a partnership? 

1) The normative theory view 

2) The proprietary view 

3) The entity view 

4) The residual equity view 

d. If one partner in a partnership acts negligently causing losses, under which form(s) of 

partnership are the other partners not held liable for these losses? 

Limited Partnership General Partnership 

1) Not liable Not liable 

2) Liable Liable 

3) Not liable Liable 

4) Liable Not liable 

24



a. 2) (120,000 + 80,000 + 100,000) x .25 = 75,000 (Bonus Method) 

Bonus: 80,000 + 100,000 + new cash 120,000 = 300,000 new book value 

Cash 120,000 

Helen, capital 75,000 

Bob, capital 22,500 

Zarai, capital 22,500 

If asset revaluation: MV = 120,000/.25 = 480,000 - 300,000 NBV = 180,000 increase 

Goodwill 180,000 

Bob, capital 90,000 

Zarai, capital 90,000 

Cash 120,000 

Helen, capital 120,000 

b. 2) $30,000 + (15% x $180,000) – $20,000 = $37,000 

c. 2) Assets – liabilities = Equity 

d. 3) 


Elmer, John, and Gill are partners in EJG Company. Their capital balances and profit and 

loss ratios are as follows: 

Capital Ratios 

Elmer $ 60,000 0.35 

John 58,000 0.35 

Gill 40,000 0.30 

Required 

Assume that Gill will retire from the partnership and that he will be paid $100,000. 

Prepare the 2 alternative journal entries to record Gill’s retirement. 

2.5 Bonus method 

Gill, capital ........................................................................... 40,000 

Elmer, capital ....................................................................... 30,000 

John, capital.......................................................................... 30,000 

Cash........................................................................................100,000 

3.5 Asset revaluation method 

Unrecorded goodwill $100,000 – 40,000 = 60,000 / 0.30 = 200,000 

Goodwill....................................................................... 200,000 

Elmer, capital (.35 x 200,000) ................................................70,000 

John, capital (.35 x 200,000) ................................................ 70,000 

Gill, capital (.30 x 200,000).................................................... 60,000 

Gill, capital............................................................................ 100,000 

Cash................................................................................................. 100,000 

25



On May 1, 2006, Nancy and Drew formed a partnership by investing $96,000 and 

$64,000 respectively. On May 1, 2007, the opening balances of the partner’s capital 

accounts were $118,000 for Nancy and $68,000 for Drew. For the fiscal year ended April 

30, 2008, net income of the partnership was $50,000. 

During the 2008 fiscal year, Nancy withdrew $2,000 per month and Drew withdrew 

$1,500 per month. Profits of the partnership are to be allocated based on a 2008 salary of 

$40,000 for Nancy and $20,000 for Drew, with the remaining profit or loss split based on 

original investment proportions. 

Required 

3 a. Determine the allocation of net income for the year ended April 30, 2008. 

3 b. Prepare a statement of partners’ capital for the year ended April 30, 2008. 

3 a. 

Nancy Drew Total 

Salaries $ 40,000 $ 20,000 $ 60,000 

Remainder 2008 

96,000 / (96,000 + 64,000) × (10,000) (6,000) (6,000) 

64,000 / (96,000 + 64,000) × (10,000) (4,000) (4,000) 

Total 2008 net income $ 34,000 $ 16,000 $ 50,000 

Notes: 

50,000 N.I. – 60,000 salary = (10,000) to allocate 

1.5 marks for each of Nancy’s and Drew’s calculations 

3 b. 

Statement of Partners’ Capital 

For the year ended April 30, 2008 

Nancy Drew Total 

Opening balance $ 118,000 $ 68,000 $ 186,000 

Share of net income 34,000 16,000 50,000 

Total 152,000 84,000 236,000 

Drawings (24,000) (18,000) (42,000) 

Ending balance $ 128,000 $ 66,000 $ 194,000 

Note: 1 mark for format; 1 mark for drawings; 1 mark for net income carry-forward from 

part (a) 

26



Allan, Betty, and Carl, the partners in ABC Catering, have agreed to liquidate the 

partnership because of declining profitability. The balance sheet on December 31, 2002, 

just prior to liquidation, is as follows: 

ABC CATERING 

Balance Sheet 


Cash $ 20,000 Accounts payable $ 175,000 

Non-cash assets 330,000 Allan, capital 16,000 

Betty, capital 35,000 

Carl, capital 124,000 

$ 350,000 $ 350,000 

The partners split profits and losses 50% to Allan, 20% to Betty, and 30% to Carl. Allan 

has had personal financial setbacks and has only $44,000 in personal assets. The other 

partners have significant personal assets. During January 2003, the non-cash assets were 

sold for a total of $200,000 and the accounts payable were paid in full. 

Required: Prepare journal entries to record the liquidation, including any entries to 

adjust and liquidate the partners’ capital balances. 

2 Cash.....................................................................................200,000 

Allan, capital (50%)................................................................65,000 

Betty, capital (20%)................................................................26,000 

Carl, capital (30%)..................................................................39,000 

Non-cash assets ............................................................................. 330,000 

1 Accounts payable ............................................................... 175,000 

Cash................................................................................................175,000 

1 Cash.......................................................................................44,000 

Allan, capital .................................................................................44,000 

3 Betty, capital .......................................................................... 2,000 

Carl, capital .............................................................................3,000 

Allan, capital ........................................................................ 5,000 

3 Betty, capital ...........................................................................7,000 

Carl, capital ............................................................................82,000 

Cash.................................................................................................89,000 

NOTE: Use T-accounts to keep track of account balances 

GOOD LUCK ON YOUE EXAM!! 

� Barbara 

27

Financial Accounting: Liabilities & Equities (FA3) Exam Review

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