16.5 Flashcards
In financial statement analysis, expressing all financial statement items as a percentage of base-year amounts is called
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.
A foreign subsidiary’s functional currency is its local currency, which has not experienced significant inflation. The weighted-average exchange rate for the current year is an appropriate exchange rate for translating
Wage Expense:
Sales to Customers:
Yes
Yes
When an entity’s local currency is the functional currency and this currency has not experienced significant inflation, translation into the reporting currency of all elements of the financial statements must be at a current exchange rate. Assets and liabilities are translated at the exchange rate at the balance sheet date. Revenues (e.g., sales), expenses (e.g., wages), gains, and losses should be translated at the rates in effect when they were recognized. However, translation of income statement items at a weighted-average rate for the period is permitted.
The following information pertains to Ali Corp. as of and for the year ended December 31:
Liabilities: $60,000
Equity: $500,000
Shares of common stock issued and outstanding: 10,000
Net income: $30,000
During the year, Ali’s officers exercised share options for 1,000 shares of stock at an option price of $8 per share. What was the effect of exercising the share options?
Debt-to-equity ratio decreased to 12%.
Exercising share options improves (decreases) the debt-to-equity ratio because equity is increased with no effect on debt. When share options are exercised, common stock and additional paid-in capital are credited and cash is debited.
Select Co. had the following financial statement relationships:
Asset turnover: 5
Profit margin on sales: 0.2
What was Select’s percentage return on assets?
10%
Asset turnover equals sales divided by average total assets, and profit margin on sales equals net income divided by sales. Since return on assets equals net income divided by average total assets, it can be derived by multiplying asset turnover and profit margin on sales (5 × .02 = 10%).
Which of the following financial instruments is not considered a derivative financial instrument?
Bank certificates of deposit.
A derivative is a financial instrument or other contract that (1) has (a) one or more underlyings and (b) one or more notional amounts or payment provisions, or both; (2) requires either no initial net investment or an immaterial net investment; and (3) requires or permits net settlement. An underlying may be a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable. A notional amount is a number of currency units, shares, bushels, pounds, or other units specified. Settlement of a derivative is based on the interaction of the notional amount and the underlying. A certificate of deposit is a financial instrument of the issuing bank that is a type of promissory note. It has no underlying and requires a material net investment. Thus, it is not a derivative.
During the current year, Rand Co. purchased $960,000 of inventory. The cost of goods sold was $900,000, and the ending inventory at December 31 was $180,000. What was the inventory turnover?
6.0
Inventory turnover is equal to cost of goods sold divided by the average inventory. Beginning inventory equals cost of goods sold, plus ending inventory, minus purchases ($900,000 + $180,000 – $960,000 = $120,000). Average inventory is equal to the average of beginning inventory and ending inventory [($120,000 + $180,000) ÷ 2 = $150,000]. Inventory turnover is thus 6.0 ($900,000 cost of goods sold ÷ $150,000 average inventory).
Which of the following is the characteristic of a perfect hedge?
No possibility of future gain or loss
A hedge is used to avoid or reduce risks by creating a relationship by which losses on certain positions are expected to be counterbalanced in whole or in part by gains on separate positions in another market. A perfect hedge is completely effective. It has a complete negative correlation with the item being hedged and results in no net gain or loss.
How is the average inventory used in the calculation of each of the following?
Acid-Test Ratio:
Inventory Turnover Ratio:
Not Used
Denominator
Assets included in the numerator of the acid-test (quick) ratio include cash, short-term investment securities, and net accounts receivable. The inventory turnover rate is equal to cost of goods sold divided by average inventory. Thus, average inventory is included in the denominator of the inventory turnover rate but is not used in the acid-test ratio.
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
$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).
The following is the equity section of Harbor Co.’s balance sheet at December 31:
Common stock $10 par, 100,000 shares authorized, 50,000 shares issued, of which 5,000 have been reacquired and are held in treasury: $450,000
Additional paid-in capital-common stock: 1,100,000
Retained earnings: 800,000
Subtotal: $2,350,000
Minus: treasury stock (at cost): (150,000)
Total stockholders’ equity: $2,200,000
Harbor has insignificant amounts of convertible securities, stock warrants, and stock options. What is the book value per share of Harbor’s common stock?
$49
The book value per share of common stock equals net assets available to common shareholders divided by ending common shares outstanding. Net assets available to common shareholders can also be stated as total equity minus liquidation value of preferred stock. Given no preferred shares, the numerator equals equity (assets minus liabilities). Thus, the book value per share of common stock is $49 [$2,200,000 equity ÷ (50,000 shares issued – 5,000 shares held in treasury)].
The following financial ratios and calculations were based on information from Kale Co.’s financial statements for the current year:
Accounts receivable turnover: Ten times during the year
Total assets turnover: Two times during the year
Average receivables during the year: $200,000
What was Kale’s average total assets for the year?
$1,000,000
The total assets turnover ratio (given as 2.0) equals net sales divided by average total assets. The accounts receivable turnover ratio (given as 10.0) equals net sales divided by average accounts receivable (it must be assumed that all sales are on credit). Given $200,000 of average accounts receivable, net sales must equal $2,000,000 ($200,000 × 10.0). Accordingly, average total assets equals $1,000,000 ($2,000,000 net revenue ÷ 2.0 total assets turnover).
Neron Co. has two derivatives related to two different financial instruments, instrument A and instrument B, both of which are debt instruments. The derivative related to instrument A is a fair value hedge, and the derivative related to instrument B is a cash flow hedge. Neron experienced gains in the value of instruments A and B due to a change in interest rates. Which of the gains should be reported by Neron in its income statement?
Gain in value of debt instrument A:
Gain in value of debt instrument B:
Yes
No
In a fair value hedge, the change in fair value of the hedged item (instrument A) is an adjustment to the carrying amount that is recognized currently in earnings. The same treatment applies to the change in fair value of the hedging instrument. The earnings effect of (gain on) the hedged item (instrument B) in this cash flow hedge occurs in a future reporting period.
On June 19, Don Co., a U.S. company, sold and delivered merchandise on a 30-day account to Cologne GmbH, a German corporation, for 200,000 euros. On July 19, Cologne paid Don in full. Relevant currency exchange rates were:
June 19
Spot rate $.988
30-day forward rate $.995
July 19
Spot rate .990
30-day forward rate 1.000
What amount should Don record on June 19 as an account receivable for its sale to Cologne?
$197,600
Foreign currency transactions should be recorded using the spot rate on the day of the transaction. Thus, Don should record a receivable on June 19 of $197,600 (200,000 euros × $.988).
Fact Pattern:
On November 15, Year 7, Hector Corp., a calendar-year-end U.S. company, signed a legally binding contract to purchase equipment from Diego Corp., a foreign company. The negotiated price is 1,000,000 FCU. The scheduled delivery date is February 15, Year 8. Terms require payment by Hector Corp. upon delivery. The terms also impose a 10% penalty on Diego Corp. if the equipment is not delivered by February 15, Year 8.
To hedge its agreement to pay 1,000,000 FCU, Hector entered into a foreign currency forward contract on November 15, Year 7, to receive 1,000,000 FCU on February 15, Year 8, at an exchange rate of 1.00 FCU = U.S.$0.36. Additional exchange rate information:
11/15/Year 7
Spot rate: 1 FCU = $0.35 U.S.
Forward rates for 2/15/Year 8: 1 FCU = $0.36 U.S.
12/31/Year 7
Spot rate: 1 FCU = $0.36 U.S.
Forward rates for 2/15/Year 8: 1 FCU = $0.38 U.S.
2/15/Year 8
Spot rate: 1 FCU = $0.39 U.S.
Forward rates for 2/15/Year 8: 1 FCU = $0.39 U.S.
Quotes obtained from dealers indicate the following incremental changes in the fair values of the forward contract based on the changes in forward rates discounted on a net-present-value basis:
11/15/Year 7 Gain/Loss:$0
12/31/Year 7 Gain Loss: $19,600
2/15/Year 8 Gain/Loss: $10,400
Hector formally documented its objective and strategy for entering into this hedge. Hector also decided to assess hedge effectiveness based on an assessment of the difference between changes in value of the forward contract and the U.S.-dollar equivalent of the purchase agreement with Diego. Because both changes are based on changes in forward rates, Hector further determined that the hedge is 100% effective.
What are the amounts reported for the forward contract receivable and the firm commitment liability at December 31, Year 7, and February 15, Year 8 (prior to the settlement of the contract between Hector and Diego)?
12/31/Yr 7:
12/31/Yr 8:
$19,600
$30,000
This hedge is a foreign currency fair value hedge because it hedges a foreign currency exposure of an unrecognized firm commitment whose cash flows are fixed. Thus, unlike a foreign currency cash flow hedge, it does not hedge the foreign currency exposure to variability in the functional-currency-equivalent cash flows associated with an unrecognized firm commitment. The forward contract receivable is recognized as an asset at fair value, with the changes in fair value recognized in earnings. Also recognized are the changes in the fair value of the firm commitment that are attributable to the changes in exchange rates. These changes in fair value are recognized in earnings and as entries to a liability. Fair values should reflect changes in the forward exchange rates on a net-present-value basis. Thus, the forward contract receivable should be debited and a gain credited for $19,600 at 12/31/Yr 7. A loss should be debited and a firm commitment liability should be credited in the same amount at the same date. (NOTE: Under current GAAP, no asset or liability is recognized for a firm commitment when the contract is signed.) At 2/15/Yr 8, a further $10,400 forward contract gain and firm commitment loss should be recorded. Because the changes in value of both the forward contract and the U.S.-dollar equivalent of the firm commitment are based on changes in forward rates, the hedge is completely effective; the changes in fair values ($19,600 and $10,400) of the forward contract receivable (gains) and the firm commitment (losses) offset each other in the income statement.
A wholly owned subsidiary of Ward, Inc., has certain expense accounts for the year ended December 31, Year 4, stated in local currency units (LCU) as follows:
LCU
Depreciation of equipment (related assets were purchased January 1, Year 2): 120,000
Provision for doubtful accounts: 80,000
Rent: 200,000
The exchange rates at various dates are as follows:
Dollar Equivalent of 1 LCU December 31, Year 4: $.40
Average for year ended 12/31/Yr 4: .44
January 1, Year 2: .50
Assume that the LCU is the subsidiary’s functional currency and that the charges to the expense accounts occurred approximately evenly during the year. What total dollar amount should be included in Ward’s Year 4 consolidated income statement to reflect these expenses?
$176,000
When the local currency of the subsidiary is the functional currency, translation into the reporting currency is necessary. Assets and liabilities are translated at the exchange rate at the balance sheet date, and revenues, expenses, gains, and losses are usually translated at average rates for the period. Thus, the 400,000 LCU in total expenses should be translated at the average exchange rate of $.44, resulting in expenses reflected in the consolidated income statement of $176,000 (400,000 LCU × $.44).
