Learning Questions and Answers for Financial Accounting, Lesson 7.3 – Mastery Level

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Read each question and provide your best possible answer. After you have gone through all the questions, read the questions again along with my answers. Keep notes of any improvements you need to make in your understanding. Repeat this process until you can answer each of these questions in your sleep. They are not terribly hard. They merely take self-discipline and a little time and thought.

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People all across the world understand the significance of these computations and make daily use of the information in their financial decision making. With a bit of effort, you can do so as well.

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(1) – Ace Company is a U.S. company located in Kentucky. It buys inventory in Europe for 10,000 euros on December 31, Year One. The purchase is made on credit with payment to be made 60 days later. Why would a U.S. company make a purchase of this size in a European country?

(2) – How much business does a company like Coca-Cola or McDonald’s do in countries outside of the U.S.?

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(3) – Ace Company buys inventory in Europe on December 31, Year One, for 10,000 euros. The amount will be paid 60 days later. Ace Company prepares its financial statements in terms of U.S. dollars. However, the inventory has a cost of 10,000 euros and the account payable is also 10,000 euros. At that point in time, one euro can be exchanged for $1.20. In preparing its Year One financial statements, how does Ace report these two balances?

(4) – In accounting for balances stated in foreign currencies, it is important to understand what monetary assets and liabilities are. Thus, what are monetary assets or liabilities?

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(5) – Ace Company buys inventory in Europe on November 30, Year One, for 10,000 euros. The amount will be paid 60 days later. Ace Company prepares its financial statements in terms of U.S. dollars. At the time of the purchase, one euro can be exchanged for $1.20. However, by the time the company is ready to create its financial statements on December 31, Year One, one euro can be exchanged for $1.30. In preparing financial statements, should the historical exchange rate at the time of purchase be used (November 30) or the current exchange rate be used (December 31)?

(6) – To report the equivalent value of foreign currency balances, the rules are straight forward. Monetary assets and liabilities are updated using the newest exchange rate. All other accounts retain the exchange rate as of the initial reporting. Is that the entire rule?

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(7) – Ace Company buys inventory in Europe on November 30, Year One, for 10,000 euros. The amount will be paid 60 days later. Ace Company prepares its financial statements in terms of U.S. dollars. At the time of the purchase, one euro can be exchanged for $1.20. However, by the time the company is ready to create its financial statements on December 31, Year One, one euro can be exchanged for $1.30. In preparing financial statements, what does Ace report for the inventory? What does Ace report for accounts payable?

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(8) – In (7), in preparing the year-end balance sheet, the inventory stays reported at the original $12,000 whereas accounts payable is now reported at $13,000. If only one account changes, the debits will not equal the credits and, therefore, the balance sheet will not balance. How is the change in accounts payable from $12,000 to $13,000 reported so the financial statements continue to balance?

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(9) – Buildings, land, salary expense, sales revenue, contributed capital, inventory, and the like are all nonmonetary accounts and use the currency exchange rate at the date of the original transaction. Cash, accounts receivable, and accounts payable update the reported amount using new exchange rates. Any movement in the reported amount of these monetary accounts is recorded as a gain or loss. Assume Ace Company buys inventory on October 15, Year One, for 10,000 euros payable in 90 days. The exchange rate is one euro equal to $1.20. On December 1, Year One, the company sells all of this inventory for 15,000 euros with the cash to be collected in 60 days. At that time, one euro is worth $1.15. However, by the end of the year, one euro is worth $1.30. As of December 31, Year One, what is reported by this company in terms of euros?

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(10) – In (9), how are each of the foreign currency balances remeasured so that they can be reported in U.S. dollars on the company’s year-end financial statements?

(11) – In (10), accounts payable and accounts receivable are both monetary accounts. Thus, the reported amount in U.S. dollars will change as the currency exchange rate moves around. Each change creates either a gain or loss. What gain or loss should this company report on its financial statements for changes in foreign currency exchange rates?

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(12) – Companies like Coca-Cola and McDonald’s must feel uncomfortable that the value of foreign currency rates can go in the wrong direction and cause them to report large losses, not on operations but on changes in foreign currency values. That risk and uncertainty must make company planning difficult. How do companies that have foreign currency balances work to eliminate the associated risk of losses?

(13) – The current ratio and the amount of working capital have been covered briefly in earlier chapters of the textbook. How is a company’s current ratio and working capital balance calculated? What information do they provide?

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(14) – Many who are interested in the financial health and wellbeing of an organization (both people inside the organization as well as outsiders) will monitor the age of its receivables. What does that computation indicate? How is it made?

(15) – Why do many people view the age of receivable as an important piece of information about a company?

(16) – Ace Company computes the age of its receivables and finds that customers take 35 days on the average to pay. Company officials want to speed up this process so they can make quicker use of the cash. What are typical techniques that companies use to encourage customers to pay quicker?

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These questions complete our coverage of Chapter Seven. Review them carefully along with the answers that follow until you are absolutely sure that you know and understand the most significant aspects of the material. That is the way to learn this material and make a good grade.

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(1) – Ace Company is a U.S. company located in Kentucky. It buys inventory in Europe for 10,000 euros on December 31, Year One. The purchase is made on credit with payment to be made 60 days later. Why would a U.S. company make a purchase of this size in a European country?

We live today in a global economy. Companies frequently buy and sell merchandise in countries around the world. This practice allows companies to find new customers in wide-ranging markets. Often, specific types of inventory can be found that are simply not available in the U.S. Purchase and sales prices might be advantageous on some transactions outside the U.S. International commerce has been common and profitable now for many decades.

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(2) – How much business does a company like Coca-Cola or McDonald’s do in countries outside of the U.S.?

According to notes to their 2019 financial statements, Coca-Cola generated 68.6 percent of its revenues outside of the U.S. while McDonald’s generated 62.8 percent of its revenues outside of the U.S. Quite obviously, many companies, especially large organizations, have extensive international operations. Thus, these companies must deal in a multitude of currencies on a daily basis. The United Nations recognizes the use of 180 different currencies around the world. Such companies as Coca-Cola and McDonald’s have to deal with many of those currencies on a regular, if not daily, basis.

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(3) – Ace Company buys inventory in Europe on December 31, Year One, for 10,000 euros. The amount will be paid 60 days later. Ace Company prepares its financial statements in terms of U.S. dollars. However, the inventory has a cost of 10,000 euros and the account payable is also 10,000 euros. At that point in time, one euro can be exchanged for $1.20. In preparing its Year One financial statements, how does Ace report these two balances?

On the day of the original transaction, the reporting of foreign currency balances is simple. The 10,000 euros is worth $12,000 (10,000 x $1.20 exchange rate). On its December 31, Year One, balance sheet, inventory will be reported as $12,000 (even though it actually cost 10,000 euros) and accounts payable will also be shown as $12,000 (even though the company owes 10,000 euros). The accounting question is: For reporting, what is an appropriate equivalent value? On the day of the transaction, the exchange rate on that date is used.

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(4) – In accounting for balances stated in foreign currencies, it is important to understand what monetary assets and liabilities are. Thus, what are monetary assets or liabilities?

In simple terms, a monetary asset or liability is one that requires the future collection or payment of a specific amount of cash. Under normal conditions, accounts receivable, notes receivables, accounts payable, notes payable, salary payable, and the like are monetary assets and liabilities because they all designate the future exchange of a set amount of cash. For an introductory course, we will just state that cash, receivables, and payables are monetary assets and liabilities. Note that neither income statement accounts nor contributed capital are monetary in nature because they all refer to transactions that took place in the past. In addition, buildings, equipment, land, and the like are not monetary because they do not have set future cash inflows. Likewise, inventory is viewed as nonmonetary for the same reason. Hopefully, inventory will create future cash collections but the exact amount is not set until the actual sale.

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(5) – Ace Company buys inventory in Europe on November 30, Year One, for 10,000 euros. The amount will be paid 60 days later. Ace Company prepares its financial statements in terms of U.S. dollars. At the time of the purchase, one euro can be exchanged for $1.20. However, by the time the company is ready to create its financial statements on December 31, Year One, one euro can be exchanged for $1.30. In preparing financial statements, should the historical exchange rate at the time of purchase be used (November 30) or the current exchange rate be used (December 31)?

About 40 years ago, FASB settled this question for U.S. GAAP and the answer has affected financial reporting for many companies since that date. Monetary assets and liabilities (cash, receivables, and payables) relate to set amounts of future cash collections and are always updated for reporting purposes using the newest exchange rate. All other accounts are nonmonetary and retain the exchange rate as of the date of initial recording for as long as the balance is reported. (1) Change monetary asset and liability balances (2) do not change any other balances.

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(6) – To report the equivalent value of foreign currency balances, the rules are straight forward. Monetary assets and liabilities are updated using the newest exchange rate. All other accounts retain the exchange rate as of the initial reporting. Is that the entire rule?

Yes, that is how it is done according to U.S. GAAP. Monetary assets and liabilities report future cash inflows and outflows so changes in the currency exchange rate does affect the value of what the company will eventually receive or pay. It seems like it should be harder but that is the rule.

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(7) – Ace Company buys inventory in Europe on November 30, Year One, for 10,000 euros. The amount will be paid 60 days later. Ace Company prepares its financial statements in terms of U.S. dollars. At the time of the purchase, one euro can be exchanged for $1.20. However, by the time the company is ready to create its financial statements on December 31, Year One, one euro can be exchanged for $1.30. In preparing financial statements, what does Ace report for the inventory? What does Ace report for accounts payable?

Inventory is a nonmonetary asset. It will stay at the $1.20 initial exchange rate until sold and always be reported as 10,000 euros times $1.20 (the original exchange rate) or $12,000. Accounts payable is a monetary liability. It will be adjusted to the new exchange rate of $1.30. On the balance sheet date, accounts payable is reported as $13,000 (10,000 euros times $1.30 -- the currency exchange rate on the balance sheet date).

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(8) – In (7), in preparing the year-end balance sheet, the inventory stays reported at the original $12,000 whereas accounts payable is now reported at $13,000. If only one account changes, the debits will not equal the credits and, therefore, the balance sheet will not balance. How is the change in accounts payable from $12,000 to $13,000 reported so the financial statements continue to balance?

Whenever the reported amount of a monetary asset or liability changes because the currency rates change, the company reports a gain or a loss. If (like here) a liability increases in value because of the fluctuation in the currency exchange rate, the company reports a loss. If the liability drops in value, the company reports a gain. If a monetary asset increases in value, that change creates a gain whereas a decrease in value leads to a reported loss. Those amounts are not necessarily trivial. In 2019, The Coca-Cola Company reported a net loss on foreign currency exchanges of $120 million. Clearly, dealing in international commerce can pose considerable risk if a company holds significant monetary assets or liabilities and currency exchange rates move in the wrong direction.

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(9) – Buildings, land, salary expense, sales revenue, contributed capital, inventory, and the like are all nonmonetary accounts and use the currency exchange rate at the date of the original transaction. Cash, accounts receivable, and accounts payable update the reported amount using new exchange rates. Any movement in the reported amount of these monetary accounts is recorded as a gain or loss. Assume Ace Company buys inventory on October 15, Year One, for 10,000 euros payable in 90 days. The exchange rate is one euro equal to $1.20. On December 1, Year One, the company sells all of this inventory for 15,000 euros with the cash to be collected in 60 days. At that time, one euro is worth $1.15. However, by the end of the year, one euro is worth $1.30. As of December 31, Year One, what is reported by this company in terms of euros?

The company has no inventory (it has all been sold) but reports cost of goods sold of 10,000 euros. It has accounts payable of 10,000 euros. In addition, it has accounts receivable of 15,000 euros and sales revenue of 15,000 euros. In terms of euros, those figures have all stayed the same. It is the equivalent value of a euro that has fluctuated which is important for reporting purposes.

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(10) – In (9), how are each of the foreign currency balances remeasured so that they can be reported in U.S. dollars on the company’s year-end financial statements?

Accounts payable is monetary and uses the current exchange rate (10,000 euros times $1.30 or $13,000). Inventory is zero so no remeasurement is needed. Accounts receivable is monetary and also uses the current exchange rate (15,000 euros times $1.30 or $19,500). Cost of goods sold is nonmonetary so it uses the exchange rate at the time of the original transaction. For this sold inventory, the original transaction was the purchase of inventory or 10,000 euros times $1.20 or $12,000. Cost of goods sold is the one tricky account since you have to remember that the original transaction for the merchandise was its purchase. Finally, sales revenue is nonmonetary so it uses its original transaction date of December 1. The reported amount is 15,000 euros times $1.15 or $17,250.

--Accounts payable 10,000 times $1.30 = $13,000 (current rate)

--Inventory is zero (although the historic rate would have been used)

--Cost of goods sold 10,000 times $1.20 = $12,000 (historic rate)

--Accounts receivable 15,000 times $1.30 = $19,500 (current rate)

--Sales revenue 15,000 times $1.15 = $17,250 (historic rate)

Coca-Cola and McDonald’s must make a tremendous number of these calculations every day. Fortunately, they can program computers to do the math.

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(11) – In (10), accounts payable and accounts receivable are both monetary accounts. Thus, the reported amount in U.S. dollars will change as the currency exchange rate moves around. Each change creates either a gain or loss. What gain or loss should this company report on its financial statements for changes in foreign currency exchange rates?

Gains and losses are only created by monetary accounts (cash, receivables, and payables). When accounts payable was created, the exchange rate was $1.20. At year’s end, the exchange rate was $1.30. Accounts payable was 10,000 euros and the exchange rate went up $.10. The reported liability rises. That creates a reported loss of $1,000 (10,000 euros times $.10 liability increase). When the accounts receivable was first created, the exchange rate was $1.15. At the end of the year, the exchange rate was $1.30. Accounts receivable was 15,000 euros and the exchange rate went up $.15. The reported receivable goes up. That creates a reported gain of $2,250 (15,000 euros times $.15 increase). A loss of $1,000 and a gain of $2,250 net to create a $1,250 foreign currency gain to be reported on the company’s income statement.

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(12) – Companies like Coca-Cola and McDonald’s must feel uncomfortable that the value of foreign currency rates can go in the wrong direction and cause them to report large losses, not on operations but on changes in foreign currency values. That risk and uncertainty must make company planning difficult. How do companies that have foreign currency balances work to eliminate the associated risk of losses?

International companies realize that, if they can maintain their monetary assets (cash and receivables) exactly equal to their monetary liabilities (payables), then any reported currency losses on one will be offset by currency gains on the other. That is referred to in business as a hedge. The gains and losses offset. It eliminates the company’s exposure to the risk of currency rate changes. For a fee, banks and other financial institutions will help companies monitor their foreign currency monetary assets and liabilities and keep them in equilibrium as much as possible. That fee is like an insurance payment that protects companies from potential catastrophe if currency rates shift dramatically.

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(13) – The current ratio and the amount of working capital have been covered briefly in earlier chapters of the textbook. How is a company’s current ratio and working capital balance calculated? What information do they provide?

The current ratio is a company’s current assets divided by its current liabilities. Working capital is current assets minus current liabilities. Both of these figures reflect a company’s liquidity, its ability to meet its cash obligations as they come due.

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(14) – Many who are interested in the financial health and wellbeing of an organization (both people inside the organization as well as outsiders) will monitor the age of its receivables. What does that computation indicate? How is it made?

The age of receivables is the average number of days that a company takes to collect cash from its customers. It is computed in a two-step process. First, credit sales for the period (if known, otherwise just total sales revenues) is divided by 365 to determine sales per day. That figure is then divided into the accounts receivable balance. The resulting figure is the number of days that the average customer takes to pay the company.

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(15) – Why do many people view the age of receivable as an important piece of information about a company?

A company cannot make use of cash from a sale until it is physically collected. That is obvious but still it is a very important concept. Until cash is collected, the company cannot use it to make more profits. So, any lengthening of this period slows down the business and can be a sign that reported profits may begin to decline because the company is having to wait longer to make use of its cash. Conversely, a speeding up of the collection period is potentially a sign of higher profits in the future. The computation provides analysts and other interested parties with a way of gauging future profitability.

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(16) – Ace Company computes the age of its receivables and finds that customers take 35 days on the average to pay. Company officials want to speed up this process so they can make quicker use of the cash. What are typical techniques that companies use to encourage customers to pay quicker?

A number of standard tactics can be used in hopes of collecting cash more quickly from customers. Unfortunately, each of these has some type of cost to the company so officials must make sure the potential benefit outweighs this cost. A short list would include the following. Spend money to modernize the billing system so customers receive invoices more quickly. Send a second invoice sooner to remind customers of their outstanding debt. Charge the customer interest if payment is not made by a particular date. Give a discount if payment is made especially fast. Reduce the number of customers who can buy on credit to only those most likely to pay.

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That completes basic coverage of Chapter Seven. Get to the point where you can easily answer each of these questions and you will be ready to move to your next assignment.

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