16.9 Flashcards
Stent Co. had total assets of $760,000, capital stock of $150,000, and retained earnings of $215,000. What was Stent’s debt-to-equity ratio?
1.08
The debt-to-equity ratio equals total liabilities divided by total equity. Total liabilities equal $395,000 ($760,000 total assets – $150,000 capital stock – $215,000 retained earnings). Consequently, the debt-to-equity ratio is 1.08 (rounded) [$395,000 ÷ ($150,000 + $215,000)].
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?
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).
Which of the following ratios is(are) useful in assessing a company’s ability to meet currently maturing or short-term obligations?
Acid-test Ratio:
Debt-to-equity Ratio:
Yes
No
The acid-test, or quick, ratio measures liquidity, which is the ability of a company to meet its short-term obligations. The debt-to-equity ratio is a leverage ratio. Leverage ratios measure the impact of debt on profitability and risk.
A December 15, Year 3, purchase of goods was denominated in a currency other than the entity’s functional currency. The transaction resulted in a payable that was fixed in terms of the amount of foreign currency, and was paid on the settlement date, January 20, Year 4. The exchange rates between the functional currency and the currency in which the transaction was denominated changed between the transaction date and December 31, Year 3, and again between December 31, Year 3, and January 20, Year 4. Both exchange rate changes resulted in gains. The amount of the gain that should be included in the Year 4 financial statements is
The gain from December 31, Year 3, to January 20, Year 4.
The change in the exchange rate between the functional currency and the currency in which a foreign currency transaction is denominated is a gain or loss. It ordinarily should be included as a component of income from continuing operations in the period in which the exchange rate changes. Thus, the amount of the gain that should be included in the Year 4 financial statements should be the gain realized from the beginning of Year 4 to January 20, Year 4.
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?
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.
U.S. GAAP require the current rate of exchange to be used for remeasuring certain balance sheet items and the historical rate of exchange for other balance sheet items. An item that should be remeasured using the historical exchange rate is
Prepaid expenses.
Financial statements are remeasured using the temporal rate method. In general, this method adjusts monetary items at the current rate and nonmonetary items at the historical rate. Prepaid expenses is a nonmonetary item that should be remeasured using the historical rate.
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.
Which one of the following would be excluded from other comprehensive income (OCI) reported for the current year?
Foreign currency remeasurement gains or losses on monetary assets and liabilities.
Foreign currency remeasurement gains or losses on monetary assets and liabilities are reported in current earnings as part of continuing operations. If the books of a foreign entity are not maintained in the functional currency, foreign currency amounts are remeasured into that currency. They are then translated into the reporting currency (if different).
On October 1, Velec Co., a U.S. company, contracted to purchase foreign goods requiring payment in euros 1 month after their receipt at Velec’s factory. Title to the goods passed on December 15. The goods were still in transit on December 31. Exchange rates were one dollar to 1.06 euros, 1.04 euros, and 1.05 euros on October 1, December 15, and December 31 respectively. Velec should account for the exchange rate fluctuation for the year as
A gain included in net income.
A receivable or payable stated in a foreign currency is adjusted to its current exchange rate at each balance sheet date. The transaction gain or loss arising from this adjustment should ordinarily be reflected in current income. Because title passed on December 15, the liability fixed in euros should have been recorded on that date at the 1.04 euro exchange rate. The increase to 1.05 euros per dollar at year-end decreases the dollar value of the liability and results in a transaction gain. Such a gain is reported as a component of income from continuing operations.
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 was the average number of days to collect accounts receivable during Year 4?
50.7
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).
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.
At the beginning of period 1, Forecast Corp. enters into a qualifying cash flow hedge of a transaction it expects to occur at the beginning of period 4. Forecast assesses hedge effectiveness by comparing the change in present value (PV) of the expected cash flows associated with the forecasted transaction with all of the hedging derivative’s gain or loss (change in fair value). The change in those cash flows that occurs for any reason has been designated as the hedged risk. The following information about the periodic changes in the hedging relationship is available:
Change in Fair Value of Derivative
Period 1: $50,000
Period 2: $47,000
Period 3: $(81,000)
Change in PV of Expected Cash Flows from the Forecasted Transaction:
Period 1: $(48,000)
Period 2: $52,000
Period 3: $80,000
Given that the hedge is effective to the extent it offsets the change in the present value of the expected cash flows on the forecasted transaction, Forecast should
Report a balance in accumulated other comprehensive income (OCI) of $16,000 at the end of period 3.
The effective portion of a cash flow hedge of a forecasted transaction is included in accumulated OCI (an equity account to which periodic OCI is closed) until periods in which the forecasted transaction affects earnings. At the end of period 3, the net change in the hedging derivative’s fair value is $16,000 ($50,000 + $47,000 – $81,000), and the change in the PV of the expected cash flows on the forecasted transaction is –$20,000 ($80,000 – $48,000 – $52,000). Thus, the hedge is effective at the end of period 3 to the extent it offsets $16,000 of the net $20,000 decrease in the cash flows of the forecasted transaction that are expected to occur in period 4.
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:
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.
Selected financial data from Drew Company follow:
As of December 31 Cash: $75,000 Accounts receivable (net): 225,000 Merchandise inventory; 270,000 Trading securities; 40,000 Land and building (net): 500,000 Mortgage payable -- current portion: 30,000 Accounts payable and accrued liabilities: 120,000 Short-term notes payable: 50,000
Year Ended December 31
Sales: $1,500,000
Cost of goods sold: 900,000
Drew’s quick (acid-test) ratio as of December 31 is
1.7 to 1.
The quick or acid-test ratio is a measure of the firm’s ability to pay its maturing liabilities in the short run. It is defined as quick assets (cash, short-term investment securities, and net receivables) divided by current liabilities. Drew Company’s quick assets equal $340,000 ($75,000 + $40,000 + $225,000). The current liabilities equal $200,000 ($30,000 + $120,000 + $50,000). Dividing the $340,000 of quick assets by the $200,000 of current liabilities results in a quick (acid-test) ratio of 1.7 to 1.
Select Co. had the following financial statement relationships:
Asset turnover: 5
Profit margin on sales: 0.02
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%).
