15.515
Mid-term Examination
October 20, 1998
Student Name: _________SOLUTION KEY_________________________________________
Section/Sea: ___________________________________
•
The exam consists of
1.
This question & answer booklet (cover sheet, plus pages numbered 1 through 7)
2.
A 6-page supplement with financial statement excerpts that are needed to answer questions 3,4, and 5.
•
There are 100 points in total -- point allocations are stated for each question.
•
Write your answers in the space provided, and show any supporting computations you make.
•
Write as legibly as possible -- we can’t grade what we can’t read!
•
If a question is unclear, make an
assumption that does not contradict any information given in the question.
•
When you are finished, hand in
the exam
the supplemental material.

QUESTION 1 (24 points)
For each of the following five transactions on pages 1, 2 and 3:
(a) record the accounting effect using EITHER a journal entry OR the Balance Sheet Equation (BSE). If you use the BSE approach, be as
specific as you would for a journal entry about the accounts and amounts affected.
(b) indicate the transaction’s effect on the Statement of Cash Flows . If the transaction does not affect the SCF, then write “No effect.”
Assume the indirect method is used for Cash Provided (Used) by Operating Activities .
The first transaction is provided as an example.
Transaction/Event
Recognize $80,000 of SG&A Expense, of which $25,000 is paid in cash.
Cash (A) = Accrued Expenses (L) + Ret. Earnings (E)
-25,000 +55,000 -80,000 ==> SG&A Expense
Statement of Cash Flows (SCF)
Operating Section a. Net Income decreased by $80,000 b. Add back $55,000 incr. in Accrued
Expense (Liability)
OR
Dr. SG&A Expense (E) $80,000
Cr. Cash (A) $25,000
Accrued Expenses (L) 55,000
Raise $500,000 cash by issuing shares of common stock
Cash (A) = Contributed Capital (E)
+500K $500K
Dr. Cash (A) $500,000
Cr. Contributed Capital (SE) $500,000
Financing Section
Cash inflow from issuing
Common Stock
+500,000
1

Transaction/Event
Ship goods with selling price of $75,000 and cost of $38,000 to distributor on account. A price protection/return policy applies to these products.
A/R (A) + Inv’y (A) = Deferred Income (L)
+ 75K (38)K +37K
Dr. Accounts Receivable $75,000
Cr. Inventory $38,000
Deferred Income Liability 37,000
Statement of Cash Flows (SCF)
Operating Section
Technically, no adjustment to NI is needed under the indirect method, because this transaction affected neither
NI nor CFO.
We also accepted, however:
Subtract $75K increase in A/R
Add back $38K decrease in Inventory
Add back $37K increase in Def. Inc.
Liab
The latter is consistent with Intel’s approach.
Declare, but do not yet pay, cash dividends totaling $5,000.
No effect = Dividend Payable (L) + Retained Earnings (SE)
+5,000 (5,000)
No effect on SCF.
Dr. Retained Earnings $5,000
Cr. Dividend Payable $5,000
2

Transaction/Event
Accrue interest of $6,400 on a loan that is financing the construction of a new production facility.
PP&E (A) = Interest Payable (L)
+6,400 +6,400
Cash Flow Statement
No effect on SCF .
Dr. PP&E $6,400
Cr. Interest Payable $6,400
Could also call the asset account “Construction in Progress.”
3

QUESTION 2: (30 points)
Consider the following three measures used in financial statement analysis:
•
Working Capital (WC) = Current Assets - Current Liabilities, representing the company's relatively liquid resources, or "liquid buffer" available to meet the financial demands of the operating cycle;
•
Rate of Return on Equity (ROE) = Net Income/Total Equity (ending balance), a profitability measure used to evaluate management effectiveness;
•
Debt to Equity Ratio (D/E) = Total Liabilities/Total Equity (ending balances), a leverage measure used to evaluate the long-run solvency of the firm.
For each of the 10 events shown below, indicate by a "+" (increase), "-" (decrease) or "0" (no effect) how the event affects each of the three measures.
Treat each event independently, as it occurs .
The adjusting entry an event may require at some later date should not affect your answer.
Assume that prior to each event the firm has
• positive values for current assets, current liabilities, debt (liabilities), equity, and net income.
•
ROE and D/E are both < 1.
1.
Insurance premium of $4,000 for one year is paid in advance.
2.
Long-term debt of $50,000 is paid off by issuing the equivalent amount of common stock. (All accrued interest had already been paid.)
3.
The company buys equipment worth $4 million by paying $1 million cash and signing a 10-year note payable for $3 million.
4.
Services worth $5,000 are performed on account for a client. The client has a good credit history, so full payment is expected.
5.
Merchandise inventory worth $200,000 is purchased on account (payable in 30 days) and delivered to the company.
6.
The company sells $50,000 of goods that cost $35,000. Cash sales account for $20,000 of the total sales.
7.
The company estimates that 2% of accounts receivable from credit sales will not be collected.
8.
$600 of accounts receivables are considered uncollectible and thus written off. A sufficient allowance for doubtful accounts was created in the past.
9.
The real estate where the company's headquarters is located increased in value by $100,000. The company has no intention to sell its headquarters.
10.
Depreciation for equipment is charged to goods produced in the current year but not yet sold (i.e., added to inventory).
0 0 0
0
-
+
0
+
-
0
0
+
-
0
+
0
+
-
0
0
0
-
+
-
+
-
+
0
0
0
4

QUESTION 3 (18 points)
In answering this question, refer to the excerpts from Nucor Corporation’s 1997 Annual Report on page 1 of the exam supplement.
a.
How much was Nucor’s LIFO reserve at the end of 1997? (2 pts)
$100,575,518
5 b.
Briefly explain how and why Nucor’s use of the LIFO cost flow assumption has affected its income taxes from the time LIFO was adopted through FY97 (no computation necessary). (5 pts)
The presence of a LIFO reserve indicates that Nucor’s taxes have been lower over the time it has used LIFO than they would have been under the FIFO assumption. From adoption through FY97, Nucor has recognized $100,575,518 more in Cost of Goods Sold than it would have under FIFO, resulting in a reduction to total taxable income of that amount.
c.
A competing firm in Nucor’s industry uses FIFO exclusively and reports a Gross Profit Margin
[(Net Revenues – COGS) / Net Revenues] of 14.8 percent. Based on Gross Profit Margin, is
Nucor or the competitor more profitable? Briefly explain. (6 pts)
Reported GP Mgn = (4,184,497,854 – 3,578,941,039) / 4,184,497,854 = 14.5 %, so on the surface, the competitor looks more profitable than Nucor.
However, the competitor uses FIFO, so its COGS is not comparable to Nucor’s. We can restate
Nucor’s
Nucor’s COGS to a FIFO basis as 3,578,941,039 -
∆
LIFO reserve = 3,552,266,452.
is restated GP Mgn = (4,184,497,854 – 3,552,266,452) / 4,184,497,854 = 15.1%, so Nucor actually more profitable than its competitor.
d.
Nucor’s Inventory Turnover Ratio (ITO) can be computed as COGS/Average Inventory Balance, or 3,578.9/[(397.0 + 385.8)/2] = 9.15. In what direction is this ratio biased by the use of LIFO?
Briefly explain how to correct for this bias (no computation necessary). (5 pts)
This ratio is overstated because it matches newer, higher costs in the numerator with older, lower costs in the denominator (as evidenced by the presence of a sizeable LIFO reserve).
The bias can be corrected by adjusting the denominator to reflect the current costs of

ending inventory,i.e., by adding the appropriate LIFO reserve numbers to the reported beginning and ending inventory values.
6

Questions 4 and 5 are based on the 1997 financial statements of Ben & Jerry’s Homemade, Inc . which appear on pages 2 - 6 of the exam supplement. All questions apply to the company’s 1997 fiscal year.
QUESTION 4 (12 points) a.
Show the Balance Sheet Equation effects (or a journal entry) to record Ben & Jerry’s bad debt expense. (3 pts)
- Allow. For Doubtful Accounts (XA) = Retained Earnings (SE)
+ $630,000 (630,000)
è
Bad Debt Expense
7 b.
Show the Balance Sheet Equation effects (or a journal entry) to record Ben & Jerry’s write-offs of uncollectible accounts (3 pts)
Accounts Receivable (A) - Allowance for Doubtful Accounts (XA) = No RHS effect
($259,000) ($259,000) c. Estimate the amount of cash Ben & Jerry’s collected from customers during the year. (6 pts)
Ending A/R = Beg. A/R + Credit Sales – Cash Collections – Write-offs
Cash Collections = Beg. A/R + Credit Sales – Write-offs – Ending A/R =
(8,684 + 695) + 174,206 – 259 – (12,710 + 1,066) = 169,550K
Note: we can either assume that all sales are initially on credit. If credit sales < total revenues,
then the difference is collected in cash upfront, so the calculation still works.

QUESTION 5 (16 points) a.
How much was Ben & Jerry’s depreciation expense? Cite your source. (3 pts)
$7,444,000 per the PP&E note on p. 6 of the supplement.
b.
How much was Ben & Jerry’s gain or loss on the sale of PP&E? Cite your source. (3 pts)
$124,000 per the SCF Operating section (loss on disposition of assets).
8 c.
What was the Acquisition Cost of the PP&E sold? Show your computation. (5 pts)
For the Gross PP&E account:
EB = BB + Acquisitions – (acquisition cost of disposals)
92,676 = 93,903 + 5,236 – (acquisition cost of disposals), so Acquisition Cost of PP&E sold was $6,463K.
d.
Show the Balance Sheet Equation effects (or a journal entry) for Ben & Jerry’s PP&E sale.
(5 pts)
Cash (A) + PP&E (A) - Accum. Depre. (XA) = Retained Earnings (SE)
+$48K ($6,463K) ($6,291K) ($124K)
The book value of the item sold equal the cash received plus the loss, or $172K.
Hence, the Accum. Deprec. associated with the item sold had to be $172K less than the original acquisition cost.