DERIVATIVES, HEDGING, AND OTHER TOPICS Flashcards
Derivatives
Financial instrument with an underlying, a notional amount, and a net settlement (such as a stock option). That could be consider an Asset or a Liability.
Derivatives Examples
Option contracts
● Future contracts
● Forward contracts
● Swap contracts- these are usually swapping fixed interest rate for a variable
rate
The foreign operation’s capital accounts would be translated to the functional currency of the reporting entity
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.
The acid-test, or quick, ratio
Measures liquidity, which is the ability of a company to meet its short-term obligations
Total Net Sales
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).
- Credit Sales - Accounts Receivable Turnover Formula
Net Credit Sales (Average of AR)/ Average Accounts Receivable
Receivable turnover ratio
The accounts receivable turnover is equal to net credit sales divided by the average accounts receivable. Collection of a receivable decreases the denominator and thus increases the ratio.
Foreign Subsidiar
Translated at Current Rates
Book value per common
Preferred shareholders equal 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).
Consolidated financial statements of a U.S. parent company with a foreign subsidiary, the foreign subsidiary’s functional currency is the currency
The method used to convert foreign currency amounts into units of the reporting currency is the functional currency translation approach. It is appropriate for use in accounting for and reporting the financial results and relationships of foreign subsidiaries in consolidated statements. This method (1) identifies the functional currency of the entity (the currency of the primary economic environment in which the foreign entity operates), (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.
Weighted-average exchange rate for the current year is an appropriate exchange rate for translating
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. It can be translating Wages Expense and Sales to Customers
What amount should Hunt report as foreign currency transaction gain
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
inventory turnover
is equal to cost of goods sold divided by average inventory. Ending inventory equals beginning inventory, plus purchases, minus cost of goods sold,
Average Inventory Turnover
Average inventory is $9,000 [($6,000 + $12,000) ÷ 2]. Inventory turnover is 2.0 times ($18,000 cost of goods sold ÷ $9,000 average inventory).
Quick (acid-test) ratio
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. 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 effect of the change should
Component of income whether the change results in a gain or a loss. When a foreign currency transaction gives rise to a receivable or a payable that is fixed in terms of the amount of foreign currency to be received or paid, a change in the exchange rate between the functional currency and the currency in which the transaction is denominated results in a gain or loss that ordinarily should be included as a component of income from continuing operations in the period in which the exchange rate changes.
intrinsic value
The intrinsic value of an option is the difference between the market value of the underlying and the exercise price of the option. The amount paid for the option is not relevant.
Firm commitment.
A firm commitment is an agreement with an unrelated party, binding on both parties and usually legally enforceable, that specifies all significant terms and includes a disincentive for nonperformance.
foreign currency transaction gain or loss
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.
interest-rate swap agreement
An interest-rate swap is an exchange of fixed interest payments for payments based on a floating rate. The risks inherent in an interest-rate swap include both credit risk and market risk. Credit risk is the risk of accounting loss from a financial instrument because of the possibility that a loss may occur from the failure of another party to perform according to the terms of a contract. Market risk arises from the possibility that future changes in market prices may make a financial instrument less valuable or more onerous. Market risk therefore includes the risk that changes in interest rates will make the swap agreement less valuable or more onerous.
Common Stock
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).
Effects of the loss and gain reported on a consolidated financial statements
Translation adjustments are gains and losses from translating financial statements from the functional to the reporting currency. They should be reported in other comprehensive income. A foreign currency transaction gain or loss ordinarily should be included as a component of income from continuing operations in the period in which the exchange rate changes. However, a gain or loss on a foreign currency transaction that hedges a net investment in a foreign entity is not included in the determination of net income but is reported in the same manner as a translation adjustment. Thus, the translation loss and the transaction gain should be reported in accumulated other comprehensive income.
Average number of days to collect accounts receivable
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).
Vertical common-size analysis
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.
debt-to-equity ratio
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)].
Increased inventory turnover ratio?
The inventory turnover ratio is equal to cost of goods sold divided by average inventory. If inventory is unchanged, an increase in cost of goods sold (the numerator) increases the ratio. A decrease in the gross profit percentage [(sales – cost of goods sold) ÷ sales] signifies an increase in cost of goods sold, given that the amount of sales is constant.
Quick Ratio
(Cash + Accounts receivable) ÷ Current liabilities
Current Ratio
Cash + Accounts receivable + Inventory) ÷ Current liabilities
Working Capital
(Cash + Accounts receivable + Inventory) – Current liabilities
Equity Ratio
Equity ÷ Total assets
Local Currency
The functional currency is the currency of the primary economic environment in which the entity operates.
Translation
Translation is the process of expressing amounts stated in the functional currency as amounts stated in the reporting currency. The euro is Jay F’s functional currency. Thus, restating euro-based amounts in U.S. dollars is foreign currency translation.
Reporting Currency
Consolidated financial statements must be stated in the reporting currency of the parent
Tempral
If the books of a foreign entity are maintained in a currency not the functional currency (euro), these foreign currency amounts must be remeasured into the functional currency using the temporal method
Transaction gain or loss.
Remeasurement expresses amounts stated in another currency as amounts stated in the functional currency. This process results in gains and losses included in earnings.
Economic indicators
The functional currency is the currency of the primary economic environment in which the entity operates. The economic indicators are characteristic of that environment.
Liquidity Ratios
Current and Quick Ratio
Activity Ratios
Inventory Turnover, Assets Turnover and Account Receiable Turn over, Fixed asset turnover
Profitability Ratio,
Profit Margin ,Return on assets, Basic earnings per share
Formula sales equals net income divided by sales. Profitability ratios measure income on a relative basis.
Leverage Ratio
Times-interest-earned ,Debt ratio, Debt-to-equity ratio
Formula - equals the sum of net income, interest expense, and income tax expense, divided by interest expense. Leverage ratios measure an entity’s use of debt to finance assets and
Foreign currency translation
The method used to convert foreign currency amounts into units of the reporting currency is the functional currency translation approach This method (a) identifies the functional currency of the entity (the currency of the primary economic environment in which the foreign entity operates), (b) measures all elements of the statements in the functional currency, and (c) uses a current exchange rate for translation from the functional currency to the reporting currency.
Interest Rate Swap
An interest rate swap is appropriate when one counterparty prefers the payment pattern of the other. For example, a firm with fixed-rate debt may have revenues that vary with interest rates. It may prefer variable-rate debt so that its debt service burden will correlate directly with its revenues.
Forward contract
Forward contracts are usually specifically negotiated agreements and are not traded on regulated exchanges. Accordingly, the parties are subject to default risk (i.e., that the other party will not perform)
Call option.
A call option allows the purchaser to benefit from an increase in price of the underlying. A call option is the right to purchase an asset at a fixed price (the exercise or strike price) on or before a future date (expiration date).
Hedge
Hedging is a defensive strategy designed to protect an entity against the risk of adverse price or interest-rate movements on certain of its assets, liabilities, or anticipated transactions
Swap
Swaps are agreements to exchange designated cash flows.
American option
An American option is an option contract that can be exercised at any time on or before the expiration date.
Strike price
Also called the exercise price, this is the price at which the holder of an option can demand to buy (if a call) or sell (if a put) the underlying.
Put Option
A put option is the right to sell an asset at a fixed (exercise or strike) price on or before the expiration date.
Futures contract.
A futures contract is a forward-based agreement to make or receive delivery or make a cash settlement that involves a specified quantity of a commodity, foreign currency, or financial instrument during a specified time interval. Futures contracts are usually standardized and exchange traded. They are therefore less risky than forward contracts.
European option
A European option is an option contract that can be exercised only on the expiration date
