16.7 Flashcards
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.
As a result of this hedging transaction, at what amount should Hector recognize the equipment on February 15, Year 8?
$360,000
The equipment should be recorded at $360,000. This amount equals $390,000 (1,000,000 FCU × $0.39 spot rate at 2/15/Yr 8) minus the $30,000 balance in the firm commitment liability account. The entry is to debit equipment for $360,000, debit the firm commitment liability for $30,000, and credit a payable for $390,000. On the same date, Hector will debit the payable for $390,000, credit the forward contract receivable for $30,000, and credit cash for $360,000. The latter entry reflects settlement of the payable and of the forward contract.
Gordon Ltd., a 100% owned British subsidiary of a U.S. parent company, reports its financial statements in local currency, the British pound. A local newspaper published the following U.S. exchange rates to the British pound at year end:
Current rate $1.50 Historical rate (acquisition) 1.70 Average rate 1.55 Inventory (FIFO) 1.60 Which currency rate should Gordon use to convert its income statement to U.S. dollars at year end?
$1.55
The method used to convert foreign currency amounts (in this case, stated in British pounds) into units of the reporting currency (the U.S. dollar) is the functional currency translation approach. It (1) identifies the functional currency of the entity (the currency of the primary economic environment in which the foreign entity operates (in this case, presumably the British pound), (2) measures all elements of the financial statements in the functional currency, and (3) uses a current exchange rate for translation from the functional currency to the reporting currency. Assets and liabilities are translated at the exchange rate at the balance sheet date. Income statement items (revenues, expenses, gains, and losses) are translated at the rates in effect when they were recognized. However, a weighted-average rate for the period may be used for these items. Consequently, the average rate should be used. Translation of income statement items at the effective rates when they were recognized is seldom feasible.
Fact Pattern:
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 $2,500
Increase over Year 3 Cash $100 Accounts receivable, net $400 Inventory $200 Prepaid expenses $40 Other assets $150 Total assets $890
What is Curry’s acid-test ratio at December 31, Year 4?
1.5
The quick assets are cash ($300), marketable securities ($0), and net accounts receivable ($1,200). The quick ratio equals quick assets ($1,500) divided by current liabilities ($1,000), or 1.5.
The following information was taken from Baxter Department Store’s financial statements:
Inventory at January 1: $100,000
Inventory at December 31: 300,000
Net sales: 2,000,000
Net purchases: 700,000
What was Baxter’s inventory turnover for the year ending December 31?
2.5
Inventory turnover is equal to cost of goods sold divided by average inventory. Cost of goods sold is equal to net purchases minus the annual increase in inventory. Thus, it equals $500,000 [$700,000 net purchases – ($300,000 – $100,000)]. Average inventory is $200,000 [($100,000 + $300,000) ÷ 2]. Inventory turnover is therefore 2.5 ($500,000 ÷ $200,000).
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
$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.
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:
Spot Rate
November 1, Year 2 $1.98
December 31, Year 2 $2.00
Forward Rate
November 1, Year 2 $2.05
December 31, Year 2 $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?
$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.
Barr Co. has total debt of $420,000 and equity of $700,000. Barr is seeking capital to fund an expansion. Barr is planning to issue an additional $300,000 in common stock and is negotiating with a bank to borrow additional funds. The bank requires a debt-to-equity ratio of .75. What is the maximum additional amount Barr will be able to borrow?
$330,000
Barr will have $1,000,000 ($700,000 + $300,000) in total equity. The debt-to-equity restriction allows up to $750,000 ($1,000,000 × .75) in debt. Barr already has $420,000 in debt, so the additional borrowing cannot exceed $330,000 ($750,000 – $420,000).
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?
$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.
Toigo Co. purchased merchandise from a vendor in England on November 20 for 500,000 British pounds. Payment was due in British pounds on January 20. The spot rates to purchase 1 pound were as follows:
November 20: $1.25
December 31: 1.20
January 20: 1.17
How should the foreign currency transaction gain be reported on Toigo’s financial statements at December 31?
A gain of $25,000 in the income statement.
Foreign currency transactions are recorded at the spot rate in effect at the transaction date. Transaction gains and losses are included in the income statement in the period the exchange rate changes. On November 20, the entity made the following entry:
Inventory (500,000 pounds × $1.25) $625,000
Accounts payable $625,000
On December 31, the entity made the following entry:
Accounts payable [500,000 pounds × ($1.25 – $1.20)] $25,000
Foreign currency transaction gain $25,000
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/Year 2 Accounts receivable $100,000 Allowance, doubtful accounts $(20,000) Sales $400,000 Cost of goods sold $350,000
12/31/Year 3 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?
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).
A useful tool in financial statement analysis is the common-size financial statement. What does this tool enable the financial analyst to do?
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.
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:
$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.
Which of the following statements regarding foreign exchange gains and losses is true (where the exchange rate is the ratio of units of the functional currency to units of the foreign currency)?
An exchange gain occurs when the exchange rate increases between the date a receivable is recorded and the date of cash receipt.
A foreign currency transaction gain or loss (commonly known as a foreign exchange gain or loss) is recorded in earnings. When the amount of the functional currency exchangeable for a unit of the currency in which the transaction is fixed increases, a transaction gain or loss is recognized on a receivable or payable, respectively. The opposite occurs when the exchange rate (functional currency to foreign currency) decreases.
he 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)].
North Bank is analyzing Belle Corp.’s financial statements for a possible extension of credit. Belle’s quick ratio is significantly better than the industry average. Which of the following factors should North consider as a possible limitation of using this ratio when evaluating Belle’s creditworthiness?
Fluctuating market prices of short-term investments may adversely affect the ratio.
The quick ratio equals cash plus short-term investment securities plus net receivables, divided by current liabilities. Because short-term investment securities are included in the numerator, fluctuating market prices of these investments may adversely affect the ratio if Belle holds a substantial amount of such current assets.
