16.3 Flashcards
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
Lore would use which of the following to determine the average days’ sales in inventory?
Numerator:
Denominator:
365
Inventory Turnover
The average days’ sales in inventory is calculated by dividing the number of days in the year by the inventory turnover.
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.
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 wholly owned foreign subsidiary of Union Corporation has certain expense accounts for the year ended December 31, Year 10, stated in local currency units (LCUs) as follows:
Amortization of patent (related patent acquired January 1, Year 8), LCU: $40,000
Provision for doubtful accounts, LCU: $60,000
Rent, LCU: $100,000
The exchange rates at various dates are as follows:
12/31/Year 10 Dollar Equivalent of 1 LCU: $.20 Average for year ended 12/31/Year 10 Dollar Equivalent of 1 LCU: $.22 January 1, Year 8 Dollar Equivalent of 1 LCU: $.25
The subsidiary’s operations were an extension of the parent company’s operations. What total dollar amount should be included in Union’s income statement to reflect the above expenses for the year ended December 31, Year 10?
$45,200
Given that the foreign subsidiary’s operations are an extension of the parent’s, the functional currency of the subsidiary is considered to be the U.S. dollar. Thus, remeasurement from the local currency to the U.S. dollar is required for financial statement purposes.
Nonmonetary balance sheet items and related revenues and expenses (e.g., cost of sales, depreciation, and amortization) should be remeasured using historical rates to produce the same results as if those items had been initially recorded in the functional currency (U.S. dollar). Accordingly, the amortization of patent expense (LCUs = 40,000) should be remeasured at the rate of exchange in effect at the date the patent was acquired, $.25. Monetary and current value items should be remeasured at a current rate. Thus, provision for doubtful accounts and rent should be remeasured at the average Year 10 exchange rate of $.22, which is the customary approximation of the current rate used to remeasure expenses not related to nonmonetary items.
Patent amortization 40,000 × $.25 = $10,000
Provision for doubtful accounts 60,000 × $.22 = 13,200
Rent 100,000 × $.22 = 22,000
Total remeasured expenses: $45,200
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.
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).
Certain balance sheet accounts of a foreign subsidiary of Rowan, Inc., at December 31, have been translated into U.S. dollars as follows:
Current Rates
Note Receivable, long term: $240,000
Prepaid rent: $85,000
Patent: $50,000
Historical Rates
Note Receivable, long term: $200,000
Prepaid rent: $80,000
Patent $170,000
The subsidiary’s functional currency is the currency of the country in which it is located. What total amount should be included in Rowan’s December 31 consolidated balance sheet for the above accounts?
$475,000
When the currency used to prepare a foreign entity’s financial statements is its functional currency, the current-rate method is used to translate the foreign entity’s financial statements into the reporting currency. This method applies the current exchange rate at the balance sheet date to assets and liabilities and historical rates to shareholders’ equity. The translation gains and losses arising from applying this method are reported in other comprehensive income in the consolidated statements and are not reflected in earnings. Because Rowan’s listed assets should be translated at current rates, $475,000 is the total amount that should be included in the consolidated balance sheet.
The following data pertain to Thorne Corp. for the current year:
Net income available to common shareholders: $240,000
Dividends paid on common stock: $120,000
Common stock outstanding (unchanged during year): 300,000 shares
The market price per share of Thorne’s common stock at December 31 was $12. The price-to-earnings ratio at December 31 was
15.0 to 1
The price-to-earnings ratio is equal to the market price divided by basic earnings per share. Basic EPS equals income available to common shareholders divided by the weighted-average common shares outstanding. Thus, basic EPS equals $.80 per share ($240,000 income available to common shareholders ÷ 300,000 shares), and the price-to-earnings ratio at year end is 15.0 to 1($12 market price ÷ $.80 basic EPS).
Selected information for Clay Corp. for the year ended December 31 follows:
Average days’ sales in inventories: 124
Average days’ sales in accounts receivable: 48
The average number of days in the operating cycle for the year was
172
The operating cycle is the time needed to turn cash into inventory, inventory into receivables, and receivables back into cash. It is equal to the sum of the number of days’ sales in inventory and the number of days’ sales in receivables. The number of days in Clay’s operating cycle is thus 172 (124 + 48).
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).
Which of the following risks, if any, are inherent in an interest-rate swap agreement?
I. The risk of exchanging a lower interest rate for a higher interest rate
II. The risk of nonperformance by the counterparty to the agreement
Both I & II.
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.
Hoyt Corp.’s current balance sheet reports the following equity:
5% cumulative preferred stock, par value $100 per share; 2,500 shares issued and outstanding: $250,000
Common stock, par value $3.50 per share; 100,000 shares issued and outstanding: 350,000
Additional paid-in capital in excess of par value of common stock: 125,000
Retained earnings: 300,000
Accumulated other comprehensive income: 100,000
Dividends in arrears on the preferred stock amount to $25,000. If Hoyt were to be liquidated, the preferred shareholders would receive par value plus a premium of $50,000. The book value per share of common stock is
$8.00
Given that the preferred stock is cumulative, the liquidation value of the preferred stock equals the par value ($250,000), plus the premium ($50,000), plus the dividends in arrears ($25,000), or $325,000. Given total equity of $1,125,000 ($250,000 + $350,000 + $125,000 + $300,000 + $100,000), common equity is $800,000 ($1,125,000 – $325,000). Thus, book value per share of common stock equals $8.00 ($800,000 ÷ 100,000 shares outstanding).
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:
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.
The contract signed by Hector Corp. to purchase the equipment from Diego Corp. meets the definition of a
Firm Commitment:
Forecasted Transaction:
Yes
No
A firm commitment is an agreement between unrelated parties, binding on both and usually legally enforceable, that specifies all significant terms and includes a disincentive for nonperformance. A forecasted transaction is a transaction that is expected to occur for which there is no firm commitment.
