16.1

Question 1

At December 31, Year 4, Curry Co. had the following balances in selected asset accounts as shown below. Curry also had current liabilities of $1,000 at December 31, Year 4, and net credit sales of $7,200 for the year then ended.

Year 4
Cash $300
Accounts receivable, net $1,200
Inventory $500
Prepaid expenses $100
Other assets: $400
Total assets 

Increase over Year 3
Cash $100
Accounts receivable, net $400
Inventory $200
Prepaid expenses $40
Other assets $150
Total assets $890

What was the average number of days to collect accounts receivable during Year 4?

Answer 1

50.7 days

The average number of days to collect receivables equals the number of days in the year divided by the accounts receivable turnover ratio (net credit sales ÷ average accounts receivable). The average accounts receivable equals $1,000 {[$1,200 + ($1,200 – $400)] ÷ 2}, and the accounts receivable turnover ratio is 7.2 ($7,200 net credit sales ÷ $1,000). Thus, the average collection period is 50.7 days (365 days ÷ 7.2).

Question 2

Utica Company’s net accounts receivable were $250,000 at December 31, Year 3, and $300,000 at December 31, Year 4. Net cash sales for Year 4 were $100,000. The accounts receivable turnover for Year 4 was 5.0. What were Utica’s total net sales for Year 4?

Answer 2

$1,475,000

Total sales equal cash sales plus credit sales. Utica’s cash sales were $100,000. Credit sales may be determined from the accounts receivable turnover formula, which equals net credit sales divided by average accounts receivable. Net credit sales are equal to 5.0 times average receivables [($250,000 + $300,000) ÷ 2], or $1,375,000. Total sales were equal to $1,475,000 ($1,375,000 + $100,000).

Question 3

On December 1, Year 1, Lombardi Company, a calendar-year-end firm, enters into a derivative contract designed to hedge the risk of cash flows associated with the forecast future sale of 300,000 bushels of wheat. The anticipated sales date is February 1, Year 2. The notional amount of the derivative contract is 300,000 bushels, the underlying is the price of the same variety and grade of wheat that Lombardi expects to sell, and the settlement date of the derivative is February 1, Year 2. The fair value of the derivative contract on December 31, Year 1, increased by $30,000, an amount equal to the decrease in the fair value of the wheat. The fair value of the derivative contract had increased by an additional $25,000 on February 1, Year 2, also an amount equal to the decrease in the fair value of the wheat. On February 1, the wheat was sold and the derivative contract was settled. The gains attributable to the increase in the fair value of the derivative that should be recognized in Year 1 and Year 2 earnings, respectively, are

Year 1:
Year 2:

Answer 3

$0
$55,000

A cash flow hedge is a hedge of an exposure to variability in the cash flows of a recognized asset or liability or a forecasted transaction. The accounting treatment of gains and losses arising from changes in fair value of a derivative designated as a cash flow hedge varies for the effective and ineffective portions. The effective portion initially is reported as other comprehensive income. It is reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion is immediately included in earnings. This hedge has no ineffective portion. Given that the sale occurred in Year 2, the $30,000 gain in Year 1 is recognized as other comprehensive income in Year 1. It is reclassified and included in earnings in Year 2. Thus, Year 2 earnings include the $30,000 reclassified from other comprehensive income and the $25,000 gain attributable to the increase in fair value in Year 2.

Question 4

Heath Co.’s current ratio is 4:1. Which of the following transactions will normally increase its current ratio?

Answer 4

Selling inventory on account.

The current ratio is equal to current assets divided by current liabilities. An increase in current assets (the numerator) or decrease in current liabilities (the denominator) would cause the ratio to increase. If the company sold merchandise on open account that earned a normal gross margin, receivables would be increased at the time of recording the sales revenue in an amount greater than the decrease in inventory from recording the cost of goods sold. The effect would be an increase in the current assets and no change in the current liabilities. Thus, the current ratio would be increased.

Question 5

Mage Corp.’s equity at December 31, Year 4, included the following:

• 6% cumulative preferred stock, $100 par; liquidating
  value $110 per share; authorized, issued, and
  outstanding 50,000 shares: $5,000,000
• Common stock, $5 par; 1,000,000 shares authorized;
  issued and outstanding 400,000 shares: 2,000,000
• Retained earnings: 1,000,000

Dividends on preferred stock have been paid through Year 3 but have not been declared for Year 4. At December 31, Year 4, Mage’s book value per common share was

Answer 5

$5.50

The preferred stock is cumulative, so the equity of the preferred shareholders equals the liquidation value plus dividends in arrears. Liquidation value is $5,500,000 (50,000 shares × $110 per share). Dividends in arrears are $300,000 [50,000 shares × $100 par per share × 6%]. The equity of the preferred is therefore $5,800,000. Given total equity of $8,000,000 ($5,000,000 + $2,000,000 + $1,000,000), common equity is $2,200,000 ($8,000,000 – $5,800,000). Consequently, book value per share of common stock equals $5.50 ($2,200,000 ÷ 400,000 shares outstanding).

Question 6

AA Company has purchased one share of QQ Company common stock and one put option. It has also sold one call option. The options are written on one share of QQ Company common stock and have the same maturity date and exercise price. The exercise price ($40) is the same as the share price. Moreover, the options are exercisable only at the expiration date. Assume that the value of a share of QQ Company common stock at the expiration date is either $30 or $45. The difference in the net payoff on the portfolio because of a difference in the stock price at the maturity date is

Answer 6

$0

If the stock price at the maturity date is $30, AA Company will have a share of stock worth $30 and a put option worth $10 ($40 exercise price – $30 stock price). The call option will be worthless. Accordingly, the net payoff is $40 ($30 + $10). If the stock price at the maturity date is $45, (1) the share of stock will be worth $45, (2) the put will be worthless, (3) the loss on the call will be $5 ($45 – $40), and (4) the net payoff will be $40 ($45 – $5). Consequently, the difference in the net payoff on the portfolio because of a difference in the stock price at the maturity date is $0 ($40 – $40). The portfolio has the same value at the maturity date regardless of the price of the stock.

Question 7

How should gains or losses from fair value hedges be recognized?

Answer 7

The gain or loss, along with the offsetting loss or gain attributable to the hedged risk, should be recognized currently in earnings in the same accounting period.

A fair value hedge mitigates the risk of changes in the fair value of a recognized asset or liability. These changes must relate to a specified risk. Gains or losses from changes in the fair value of the hedging instrument are recognized immediately in earnings. Also, gains or losses from changes in the fair value of the hedged item attributable to the hedged risk are recognized immediately in earnings. Thus, a fully effective hedge results in no net gain or loss. It occurs when the gain or loss on the hedging instrument exactly offsets the loss or gain on the hedged item.

Question 8

In financial statement analysis, expressing all financial statement items as a percentage of base-year amounts is called

Answer 8

Horizontal common-size analysis.

Expressing financial statement items as percentages of corresponding base-year figures is a horizontal form of common-size (percentage) analysis that is useful for evaluating trends. The base amount is assigned the value of 100%, and the amounts for other years are denominated in percentages compared to the base year.

Question 9

In assessing the financial prospects for a firm, financial analysts use various techniques. Which of the following is an example of vertical common-size analysis?

Answer 9

A statement that current advertising expense is 2% of sales.

Vertical common-size analysis compares the components within a set of financial statements. A base amount is assigned a value of 100%. For example, total assets on a common-size balance sheet and net sales on a common-size income statement are valued at 100%. Common-size statements permit evaluation of the efficiency of various aspects of operations. An analyst who states that advertising expense is 2% of sales is using vertical common-size analysis.

Question 10

A company’s foreign subsidiary operation maintains its financial statements in the local currency. The foreign operation’s capital accounts would be translated to the functional currency of the reporting entity using which of the following rates?

Answer 10

Historical exchange rate.

If the books of a foreign entity are maintained in a currency not the functional currency, foreign currency amounts must be remeasured into the functional currency using the temporal method. Under this method, nonmonetary balance sheet items such as capital accounts are remeasured at the historical exchange rate. Monetary items such as receivables are remeasured at the current exchange rate.

Question 11

Gil Corp. has current assets of $90,000 and current liabilities of $180,000. Which of the following transactions would improve Gil’s current ratio?

Answer 11

Purchasing $50,000 of merchandise inventory with a short-term account payable.

If a ratio is less than 1.0, a transaction that results in equal increases in the numerator and denominator will improve the ratio. Gil’s current ratio is .5 ($90,000 ÷ $180,000). Debiting inventory and crediting accounts payable increases the ratio to .61 ($140,000 ÷ $230,000).

Question 12

A foreign subsidiary of a U.S. parent company should measure its assets, liabilities, and operations using

Answer 12

The subsidiary’s functional currency.

The functional currency is the currency of the primary economic environment in which the entity operates. Normally, that environment is the one in which it primarily generates and expends cash. The subsidiary’s functional currency is the currency that is used to measure its liabilities, assets, and operations. At the date a foreign currency transaction is recognized, each asset, liability, revenue, expense, gain, or loss resulting from the transaction must be measured in the functional currency of the recording entity. If an entity’s books of record are not maintained in its functional currency, remeasurement into the functional currency is required before translation into the reporting currency.

Question 13

The following information is available from Timber Corp.’s financial records for the current year:

Net credit sales: $500,000
Net cash sales: 250,000

Balance, January 1: $75,000
Balance, December 31: 50,000

How many times did Timber’s accounts receivable turn over during the year?

Answer 13

8

The accounts receivable turnover is equal to net credit sales divided by the average accounts receivable. Net credit sales is $500,000 and average accounts receivable is $62,500 [($75,000 + $50,000) ÷ 2]. Accounts receivable turnover is thus 8 × ($500,000 ÷ $62,500).

Question 14

At December 30, Vida Co. had cash of $200,000, a current ratio of 1.5:1, and a quick ratio of .5:1. On December 31, all cash was used to reduce accounts payable. How did these cash payments affect the ratios?

Current ratio:
Quick ratio:

Answer 14

Increased
Decreased

The current ratio (1.5) equals current assets (cash, marketable securities, and net accounts receivable) divided by current liabilities (accounts payable, etc.). If a ratio is greater than 1.0, equal decreases in the numerator and denominator (debit accounts payable and credit cash for $200,000) increase the ratio. The quick ratio (.5) equals quick assets (cash, trading securities, net accounts receivable) divided by current liabilities. If a ratio is less than 1.0, equal decreases in the numerator and denominator (debit accounts payable and credit cash for $200,000) decrease the ratio.

Question 15

On June 1, Year 1, ABC Co. issued a 200,000 euro purchase order for equipment to be supplied by a German company. ABC’s functional currency is the U.S. dollar. The equipment was delivered to ABC on November 1, Year 1, and ABC recorded a payable due to the German company. ABC paid for the equipment on January 31, Year 2. The following are the exchange rates in effect:

June 1, Year 1: 1 euro = 1.40 U.S. dollars
November 1, Year 1: 1 euro = 1.50 U.S. dollars
December 31, Year 1: 1 euro = 1.35 U.S. dollars
January 31, Year 2: 1 euro = 1.30 U.S. dollars

What is the foreign currency gain or loss that ABC should record for the year ended December 31, Year 1?

Answer 15

A gain of $30,000

The terms of a foreign currency transaction are stated in a currency different from the entity’s functional currency. The initial measurement of the transaction must be in ABC’s functional currency (U.S. dollar). The exchange rate used is the rate in effect on the date the transaction was initially recognized. On 11/1/Year 1, ABC initially recognized a payable to a German company of $300,000 (200,000 euros × 1.5 exchange rate on 11/1/Year 1) because the equipment was delivered on that date. A foreign currency transaction gain or loss is recognized in the period when the exchange rate changes, e.g., at a balance sheet date and at the settlement date. On 12/31/Year 1, a payable is reported at $270,000 (200,000 euros × 1.35 exchange rate on 12/31/Year 1). The decrease in the payable of $30,000 ($270,000 – $300,000) is recognized as a gain in the Year 1 income statement.

Question 16

A useful tool in financial statement analysis is the common-size financial statement. What does this tool enable the financial analyst to do?

Answer 16

Compare the mix of assets, liabilities, capital, revenue, and expenses within a company over time or between companies within a given industry without respect to relative size.

A common-size financial statement presents the items in a financial statement as percentages of a common base. The items in a balance sheet are usually stated in percentages of total assets. The items in the income statement are usually expressed as a percentage of sales. Thus, comparisons among firms in the same industry are possible despite differences in size. Comparison of firms in different industries has drawbacks because the optimal mix of assets, liabilities, etc., will vary from industry to industry.

Question 17

The controller of Peabody, Inc., has been asked to present an analysis of accounts receivable collections at the upcoming staff meeting. The following information is used:

12/31/1
Accounts receivable $100,000
Allowance, doubtful accounts $(20,000)
Sales $400,000
Cost of goods sold $350,000

12/31/2
Accounts receivable $130,000
Allowance, doubtful accounts $(40,000)
Sales $200,000
Cost of goods sold $170,000

What is the receivables turnover ratio as of December 31, Year 2?

Answer 17

4.7

The receivables turnover ratio equals net revenue divided by average net receivables. Net receivables at the end of Year 1 and Year 2 were $90,000 ($130,000 – $40,000) and $80,000 ($100,000 – $20,000), respectively. The average was $85,000 [($90,000 + $80,000) ÷ 2]. Hence, the receivables turnover ratio for Year 2 was 4.7 times ($400,000 ÷ $85,000).

Question 18

A company’s year-end balance sheet is shown below:

Assets
Cash: $300,000
Accounts receivable: 350,000
Inventory: 600,000
Property, plant, and equipment (net): 2,000,000
$3,250,000

Liabilities and Shareholder Equity
Current liabilities: $700,000
Long-term liabilities: 600,000
Common stock: 800,000
Retained earnings: 1,150,000
$3,250,000

What is the current ratio as of December 31?

Answer 18

1.79

The current ratio equals current assets divided by current liabilities [($300,000 + $350,000 + $600,000) ÷ $700,000 = 1.79].

Question 19

On September 1, Year 2, Cano & Co., a U.S. corporation, sold merchandise to a foreign firm for 250,000 local currency units (LCUs). Terms of the sale require payment in LCUs on February 1, Year 3. On September 1, Year 2, the spot exchange rate was $0.20 per LCU. On December 31, Year 2, Cano’s year-end, the spot rate was $0.19, but the rate increased to $0.22 by February 1, Year 3, when payment was received. How much should Cano report as foreign currency transaction gain or loss in its Year 3 income statement?

Answer 19

$7,500 gain

A receivable or payable stated in a foreign currency should be recorded at the current exchange rate and then adjusted to the current exchange rate at each balance sheet date. That adjustment is a foreign currency transaction gain or loss that is ordinarily included in earnings for the period of change. Furthermore, a gain or loss measured from the transaction date or the most recent intervening balance sheet date is recognized when the transaction is settled. Accordingly, Cano should recognize a foreign currency transaction gain of $7,500 [250,000 LCUs receivable × ($0.22 – $0.19)] in Year 3.

Question 20

On November 1, Year 2, Kir Co. signed a contract to purchase 10,000 British pounds on February 2, Year 3. The relevant exchange rates are as follows:

November 1, Year 2
Spot rate: 1.98
Forward rate: 2.05

December 31, Year 2
Spot rate: 2.00
Forward rate: 2.06

Kir accounts for the forward contract as a speculative transaction. What amount of gain, if any, should Kir report from this forward contract in its income statement for the year ended December 31, Year 2?

Answer 20

$100

A forward contract (a derivative instrument) is an agreement for the purchase and sale of a stated amount of a commodity, foreign currency, or financial instrument at a stated price. Delivery or settlement is at a stated future date. Fair value is the only relevant measure for derivatives. The fair value of a forward exchange contract is based on its forward rates. Since the transaction is accounted for as a speculative transaction, the gains or losses are included in earnings in the period of change. The spot rate is the rate for immediate exchange of currencies, whereas the forward rate is the rate on the contracted future date (i.e., delivery/settlement date). The purchasing party is only obligated to pay the forward rate existing on the contract date. Therefore, the purchasing party realizes a gain when the forward rate increases. Here, Kir has a forward contract involving foreign currency. Kir will recognize a gain because the forward rate at year end is higher than the forward rate on the contract date. The gain is measured as the difference in forward rates multiplied by the units of currency. Accordingly, Kir will report a total gain of $100 [($2.06 – $2.05) × 10,000 British pounds] from the forward contract on its year-end income statement.