Guided Readings for Financial Accounting, Lesson 7.3 – Mastery Level
SUGGESTION: Read the fifth section of Chapter Seven (“Reporting Foreign Currency Balances”). Virtually all companies of any size have some balances denominated in a foreign currency such as Euros, Yen, or Pounds. The currency exchange rates between U.S. dollars and other such currencies fluctuate constantly. Decision makers need to know the effect that these currency rate changes have on a company’s reported balances.
To illustrate, assume a company operates in the U.S. but has one account balance in its ledger that is stated as 100 Euros because of a transaction in Europe several months ago. When the balance was created, one Euro was worth $1.20. Now, one Euro is worth $1.25. In reporting this account in U.S. dollars, should the company use $1.20 for reporting or $1.25? That is the basic accounting question for foreign currency balances.
(7Q27) – According to U.S. GAAP, the reported value of a monetary asset or monetary liability denominated in a foreign currency must be adjusted to the current rate whenever the currency exchange rate changes. The reported value of all other accounts simply remains at the original historic exchange rate and never changes. What is a monetary asset? What is a monetary liability?
(7A27) – Monetary assets and monetary liabilities are cash and all other balances that require a specific cash transfer in the future. Thus, cash, accounts receivable, and notes receivable are all monetary assets. Accounts payable, notes payable, salary payable, rent payable, and the like are all monetary liabilities. Inventory is not viewed as a monetary asset because the future cash amount is not absolutely set.
(7Q28) – On Monday, a U.S. company buys inventory in Europe for 10,000 Euros on account. On that day, one Euro is worth $1.20. On Thursday, the company prepares financial statements but one Euro is now worth $1.25. The liability has not been paid nor has the inventory been sold. What recorded balances are appropriate on Monday? What figures are reported on the balance sheet on Thursday?
(7A28) – On Monday, 10,000 Euro are worth $12,000 (at the $1.20 exchange rate). Both the inventory and the accounts payable are recorded at $12,000. Thereafter, all reported values for monetary assets and monetary liabilities denominated in a foreign currency are adjusted whenever the exchange rate changes. On Thursday, 10,000 Euro at $1.25 is $12,500. Inventory is not a monetary asset so it stays reported at $12,000. Accounts payable is a monetary liability and is now reported at $12,500.
(7Q29) – On Monday, a U. S. company buys inventory in Europe for 10,000 Euros on account. On Monday, one Euro is worth $1.20. On Thursday, the company prepares financial statements but one Euro is now worth $1.25. The liability has not been paid nor has the inventory been sold. Inventory continues to be reported at $12,000 but accounts payable is adjusted for reporting purposes from $12,000 to $12,500. What income effect, if any, is reported as a result of this adjustment?
(7A29) – The reported liability is increased by $500 when the balance is adjusted from $12,000 to $12,500. Because the reported liability is increased, a $500 loss must be recognized on the company’s income statement. The reported balance of inventory stays at $12,000 so no income effect is created. Inventory is not a monetary account.
(7A29-Continued) – Note that the liability balance actually stays at 10,000 Euros. That is not the question. The question is how this balance is reported in U.S. dollars. What is the equivalent amont? As a monetary liability, the equivalent amount in U.S. dollars changes from $1.20 to $1.25 so that is what is reported on the balance sheet. The actual liability is still 10,000 Euros.
(7Q30) – During Year One, Acme Company had a number of transactions in countries located outside the U.S. As a result, each of the following accounts had a balance denominated in a foreign currency such as the Euro. At the end of Year One, which of these accounts are reported at the historic exchange rate and which are adjusted to the current currency exchange rate: (1) Land, (2) Rent Expense, (3) Sales Revenue, (4) Accounts Receivable, (5) Notes Payable, (6) Inventory.
(7A30) – For accounts denominated in a foreign currency, all monetary assets and monetary liabilities are adjusted to the current rate whenever a new exchange rate is established (and a gain or loss is created). All other accounts continue to be reported at the historic exchange rate when originally recorded. (1) Land – Historic Rate, (2) Rent Expense – Historic Rate, (3) Sales Revenue – Historic Rate, (4) Accounts Receivable – Current Rate, (5) Notes Payable – Current Rate, (6) Inventory – Historic Rate.
SUGGESTION: Work the Test Yourself question in Section 7.5 of Chapter Seven (“The Hamerstein Company is considering …”). The company buys land in Japan and signs a note payable denominated in yen. At the end of the year, the currency exchange rate for the Japanese yen has changed. How does that change affect the company’s financial reporting? Three of the statements in this problem are true. One is not. Which is not true and why?
The following statement is included in the end-of-chapter material as a True or False question. “A U.S. company with the U.S. dollar as its functional currency makes a sale in a foreign country and agrees to receive 20,000 vilsecks, the local currency. A vilseck is worth $.42 on that date but is worth only $.39 later on the balance sheet date. On its income statement, the company should report a sale of $7,800.” That statement is False. Why is the statement False?
The previous statement is False. A sale is made and recorded at the U.S. dollar equivalent of 20,000 vilsecks times $.42 or $8,400. The sales account is not a monetary asset or monetary liability. Therefore, it will always remain reported at $8,400 regardless of the currency exchange rate. It is not adjusted to $7,800. The statement is False.
Near the end of the section of the textbook titled “Reporting Foreign Currency Balances,” there is a link for a video that is also titled “Reporting Foreign Currency Balances.” Most companies of any size will have some (possibly many) transactions in a foreign currency. How are those balances reported especially as the currency exchange rates change. This video should help reinforce what you learned from the textbook.
SUGGESTION: Read the sixth section of Chapter Seven (“A Company’s Vital Signs—Accounts Receivable”). Financial analysts often use reported accounting information to determine key ratios or important balances. In this section, several of these computations that involve accounts receivable are described and discussed.
(7Q31) – At the end of the current year, Ace Company officials determine that the company is taking several days longer to collect its accounts receivable than in the previous year. How was this computation made?
(7A31) – The age of accounts receivable is determined in a two-step process. First, sales on account for the year are divided by 365 to calculate the average amount of credit sales per day. Second, this credit sales per day figure is divided into the accounts receivable balance. The result is the average time the company takes to collect its receivables.
(7Q32) – Why do company officials usually monitor the age of accounts receivable so closely? Why is the age considered to be significant?
(7A32) – Company officials prefer to collect cash from accounts receivable as fast as possible so the money can be used to generate more profits. Unless interest is charged on a receivable, no revenue is generated while the company waits for its money. The quicker cash is collected, the quicker it can be used to buy more inventory or used in other ways to generate future revenues. In addition, older accounts are more likely to become uncollectible so that no money is ever collected. Quick collection is typically preferred.
(7Q33) – Officials for the Webb Company want to collect cash from receivables more quickly so the money can be reinvested. How might a company reduce the number of days it takes to collect accounts receivable? This is not an accounting question but rather a management question using financial accounting data.
(7A33) – Companies often employ a number of techniques to reduce the length of time it takes to collect money from accounts receivables. Invoices can be sent to customers faster and follow up notices mailed on a more timely basis. Credit granting policies and collection procedures can be strengthened. Discounts for quick payment can be offered. Interest can be charged on delinquent balances. Unfortunately, these steps all have a cost so company officials must determine whether the potential benefit outweighs the cost.
SUGGESTION: Work the second Test Yourself question in Section 7.6 of Chapter Seven (“The Yang Corporation recently extended …”). This problem looks at the computation of the age of accounts receivable – either by days or by determination of the receivable turnover rate. Make sure you know how to make these computations. Read the explanation carefully.