16.8 Flashcards
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?
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.
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/Year 7:
2/15/Year 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.
Park Co.’s wholly owned subsidiary, Schnell Corp., maintains its accounting records in euros. Because all of Schnell’s branch offices are in London, its functional currency is the British pound. Remeasurement of Schnell’s Year 4 financial statements resulted in a $7,600 gain, and translation of its financial statements resulted in an $8,100 gain. What amount should Park report as a foreign currency transaction gain in its income statement for the year ended December 31, Year 4?
$7,600
The financial statements must be remeasured into the functional currency using the temporal method and then translated into the reporting currency using the current rate method. The $7,600 gain arising from remeasurement should be reported in current income. The $8,100 translation gain should be reported in other comprehensive income and is not reflected in income.
Which of the following is the characteristic of a perfect hedge?
No possibility of future gain or loss.
The following data pertain to Cowl, Inc., for the year ended December 31, Year 4:
Net sales: $600,000
Net income: 150,000
Total assets, January 1, Year 4: 2,000,000
Total assets, December 31, Year 4: 3,000,000
What was Cowl’s rate of return on assets for Year 4?
6%
Return on assets equals net income ($150,000) divided by average total assets [($2,000,000 + $3,000,000) ÷ 2 = $2,500,000], or 6%.
A derivative financial instrument is best described as
A contract that has its settlement value tied to an underlying notional amount.
A derivative is a bet on whether the value of something (underlying notional amount) will go up or down. A derivative has at least one underlying (interest rate, currency exchange rate, price of a specific financial instrument, etc.) and at least one notional amount (number of units specified in the contract) or payment provision, or both. No initial net investment, or one smaller than that necessary for contracts with similar responses to the market, is required. Furthermore, a derivative’s terms require or permit net settlement or provide for the equivalent. Net settlement means that the derivative can be readily settled with only a net delivery of assets. Thus, neither party must deliver (1) an asset associated with its underlying or (2) an asset that has a principal, stated amount, etc., equal to the notional amount.
TGR Enterprises provided the following information from its statement of financial position for the year ended December 31, Year 1:
January 1 Cash $10,000 Accounts receivable $120,000 Inventories $200,000 Prepaid expenses $20,000 Accounts payable $175,000 Accrued liabilities $25,000
December 31 Cash $50,000 Accounts receivable $100,000 Inventories $160,000 Prepaid expenses $10,000 Accounts payable $120,000 Accrued liabilities $30,000
TGR’s sales and cost of sales for Year 1 were $1,400,000 and $840,000, respectively. What is the accounts receivable turnover in days?
28.7
The accounts receivable turnover in days equals the number of days in the year divided by the accounts receivable turnover (sales ÷ average accounts receivable). Thus, using a 365-day year, the number of days in receivables is 28.7 [365 ÷ ($1,400,000 ÷ $110,000)].
The assets, liabilities, and operations of a foreign entity are to be measured using that entity’s functional currency. The functional currency of an entity is defined as the currency
Of the primary economic environment in which the entity operates.
The functional currency of an entity is defined as 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.
A company from the United Kingdom uses British pounds in its normal operations, reports in the European Union in euros, and reports in the United States in U.S. dollars. The company is owned by a private equity firm in Japan. What is the company’s functional currency?
The British Pound.
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. Because the company uses the British pound in its normal operations, the British pound is the functional currency.
Fact Pattern:
Selected data pertaining to Lore Co. for the Year 4 calendar year is as follows:
Net cash sales: $3,000
Cost of goods sold: 18,000
Inventory at beginning of year: 6,000
Purchases: 24,000
Accounts receivable at beginning of year: 20,000
Accounts receivable at end of year: 22,000
The accounts receivable turnover for Year 4 was 5.0 times. What were Lore’s Year 4 net credit sales?
$105,000
Credit sales may be determined from the accounts receivable turnover formula (credit sales ÷ average accounts receivable). Credit sales are equal to 5.0 times average receivables [($20,000 + $22,000) ÷ 2], or $105,000.
Zenk Co. wrote off obsolete inventory of $100,000 during the year. What was the effect of this write-off on Zenk’s ratio analysis?
Decrease in current ratio but not in quick ratio.
Inventory is included in the numerator of the current ratio but not the quick ratio. Consequently, an inventory write-off decreases the current ratio but not the quick ratio.
What effect would the sale of a company’s trading securities at their carrying amounts for cash have on each of the following ratios?
Current Ratio:
Quick Ratio:
No effect
No effect
The current ratio equals current assets divided by current liabilities. The sale of trading securities at their carrying amounts for cash has no net effect on the current ratio (both accounts are in the numerator). The quick ratio equals the quick assets (current assets minus inventory and prepaids) divided by current liabilities. The sale of trading securities has no net effect on the numerator and therefore no effect on the quick ratio.
At December 30, Solomon Co. had a current ratio greater than 1:1 and a quick ratio less than 1:1. On December 31, all cash was used to reduce accounts payable. How did these cash payments affect the ratios?
Current ratio
Quick ratio:
Increased
Decreased
This transaction reduced the numerator and the denominator of both ratios by equal amounts. The effect is to increase a ratio greater than 1:1 and to decrease a ratio lower than 1:1. Thus, the current ratio increased and the quick ratio decreased.
Fact Pattern:
As part of its risk management strategy, Copper Monkey Mining sells futures contracts to hedge changes in fair value of its inventory. On March 12, the commodity exchange spot price was $0.81/lb., and the futures price for mid-June was $0.83/lb. On that date, Copper Monkey, which has a March 31 fiscal year end, sold 200 futures contracts on the commodity exchange at $0.83/lb. for delivery in June. Each contract was for 25,000 lb. Copper Monkey designated these contracts as a fair value hedge of 5 million lb. of current inventory for which a mid-June sale is expected. The average cost of this inventory was $0.58/lb. Copper Monkey documented (1) the hedging relationship between the futures contracts and its inventory, (2) its objectives and strategy for undertaking the hedge, and (3) its conclusion that the hedging relationship will be highly effective. On March 31, the mid-June commodity exchange futures price was $0.85/lb.
In the March 31 statement of financial position, the company should record the futures contracts as a
$100,000 liability.
GAAP require that derivative instruments be recorded as assets and liabilities and measured at fair value. At the inception of the futures contracts, their fair value was $0 because the contracts were entered into at the futures price at that date. On March 31, the fair value of the futures contracts is equal to the change in the futures price between the inception price and the price on the balance sheet date. Given that the futures contracts created an obligation to deliver 5 million lb. (25,000 lb. × 200 contracts) of copper at $0.83/lb. and that the price had risen to $0.85/lb. at the date of the financial statements, Copper Monkey should record a loss and a liability of $100,000 [5 million lb. × ($0.83 – $0.85)].
Hunt Co. purchased merchandise for 300,000 British pounds from a vendor in London on November 30, Year 4. Payment in British pounds was due on January 30, Year 5. The exchange rates to purchase one pound were as follows:
November 30, Year 4
Spot rate 1.65
30-day rate 1.64
60-day rate 1.63
December 31, Year 4
Spot rate 1.62
30-day rate 1.59
60-day rate 1.56
In its December 31, Year 4, income statement, what amount should Hunt report as foreign currency transaction gain?
$9,000
Gains and losses from fluctuations in the exchange rate are ordinarily reflected in income when the rate changes. The foreign currency transaction gain is the difference between the spot rate on the date the transaction originates and the spot rate at year-end. Thus, the gain for Hunt Co. is $9,000 [300,000 British pounds × ($1.65 – $1.62)].
