Acct6007 Financial Accounting : Risk Assessment Answers

1.Exports Ltd sells goods to a company based in the United States on 1 April 2017. The invoice is denominated in the US dollars, and is $US750 000. The invoice will be due on 31 May 2017. The amount is guaranteed by a local bank so the payment is certain. The sport rate of the date of transaction is $A1 = $US0.75.

Exports Ltd is concerned that the A$ will fluctuate and thus decides to enter a forward-rate agreement with the bank. According to the agreement, the bank agrees to buy $US 750 000 from Exports Ltd on 31 May 2017 at an agreed forward rate of $A1 = $US0.80.

i. Explain how Exports Ltd has reduced the risk of $A fluctuation by entering theforward-rate agreement. 

ii. How much will Exports Ltd receive from the sale of US$750 000 to the bank, in Australian dollars?

2.Darlington Corporation has the extracted statement of financial position as at 30th June 2017 below:

Statement of financial position before set-off

Loans payable $1 500 000 Loans Receivable $1 800 000

Shareholders’ equity $1 500 000 Non-current assets 1 200 000

$3 000 000 $3 000 000

In addition, Darlington Corporation has an amount of $450 000 owing to Seaview Ltd, and an amount of $600 000 receivable from Seaview Ltd.

i. Assuming a right of set-off exists. Why would Darlington Corporation want to perform a set-off with Seaview Ltd? 

ii. What would be the impact on the debt to asset ratio and the debt to equity ratio of Darlington Corporation, which result from the set-off with Seaview Ltd?

iii. Prepare a post set-off statement of financial position for Darlington Corporation.

1.i. Fluctuation in currency presents significant risk to business of exports Ltd as it gives uncertainty in receiving and making international payments. In such situation, traders make use of some investment tool for mitigating the risk associated with carrying out such transaction. In the given case, Exports Ltd is required to another party in US dollars. The spot rate of US dollar is at $A1= 0.75. Therefore, to avoid the risk of currency fluctuation, Exports limited has entered into forward contract. Forward contract is a contract between two parties that is non-standardized to buy or sell an asset at specified price and at particular future price. The contract is an obligation on both the parties to perform their rights. Here, Exports Ltd is to sell an asset of US $ 750000 to banks at an agreed price of $A1= $US 0.80. Forward contract would allow customers to take the benefit of favorable exchange rate as it is locked so that transactions can be expected in future date. This investment tool proves to be beneficial when there is deterioration in exchange rate.

Expiration date of forward contact that Export Ltd has entered into is two months as bank would buy and trader would sell $ 750000 on 31^st May. Here, Exports Ltd is taking short forward position since he would benefit if the underlying assets price falls. If it is assumed that the price of asset has dropped to $A1= US 0.70, he has the right to charge $ US 0.80 for his goods. Therefore, Exports Ltd is benefitting from entering into the forward contract, as he is able to sell goods at higher price if there is deterioration in value of currency. On other side, when the exchange rate or currency value appreciates to $A1= $ US0.82. In this case, Exports Ltd would loses, as he is obliged to sell the goods at $ US 0.80 when the current market price is $ US0.82. Other party buying the underlying assets wins as it is required to pay only $ US 0.80 when the market rate is $ US0.82.

From the above discussion on forward contract entered by Exports Ltd, it can be said that such agreement would be beneficial only when the currency value deteriorates. In the event of currency depreciation of falling currency value, the other party is buyer who would benefit from the contract. Since, it is an obligation both the parties have to execute the contract.

ii.Exports Ltd. will receive $A 937,500 from the sale of US$ 750,000 to the bank as per the following calculation:

Receipt from Sale of US Dollars:
Particulars		Amount
Invoice Amount (in $US)	A	$750,000
Forward Rate (in $US)	B	$0.80
Receipt from Bank in Australian Dollar (in $A)	C=A/B	$937,500

2.i.

In the books of Darlington Corporation
Journal Entries
			Dr.	Cr.
Date	Particulars		Amount	Amount
30/06/2017	Loans Payable - Seaview Ltd. A/c.		$450,000
		Loans Receivable - Seaview Ltd. A/c.		$450,000
	(Being the dues from Seaview Ltd. set off against the dues to Seaview Ltd.)

Seaview Ltd owes $ 450000 amount of debt to Dralington Corporation and the latter is paying amount of $ 600000 to former. In this case, it can be seen that the minimum amount that can be set off by Seaview is $ 450000. Setting of amount will help in reducing the total liability of business and thereby its financial burden.

ii.

Impact on the Financial Leverage:
Particulars		Before Set off		After Set off	Impact
Loans Payable	A	$1,500,000	A	$1,500,000
Loans Receivable	B	$1,800,000	B	$1,800,000
Shareholders, Equity	C	$1,500,000	C	$1,500,000
Non-Current Assets	D	$1,200,000	D	$1,200,000
Set-Off Amount			E	$450,000
Debt-to-Asset Ratio	F=A/D	1.25	F=(A-E)/D	0.88	0.38
Debt-to-Equity Ratio	G=A/C	1	G=(A-E)/D	0.70	0.30

From the above table, it can be seen that debt to asset ratio has fallen after conducting set off. Before set off, debt to asset ratio stood at 1.25 and it reduced to 0.88. There was a fall in debt to asset ratio by 0.38. A fall in debt to asset ratio is indicative of the fact that financial risk of business has reduced. After set off, the debt burden of Darlington has reduced. Now looking at debt to equity ratio, it can be seen that there was similar impact after set off. Debt to equity ratio stood at 1 and this fell to 0.70 after carrying out set off. There was equal stake of creditors and investors in business before set off. Falling ratio depicts that there is financial stability in business. It also indicates that shareholders are funding the business operations that is considered favorable as reliability of business on debt has fallen.

ii.

In the books of Darlington Corporation
Statement of Financial Position (after set-off)
Particulars	Amount	Amount	Particulars	Amount	Amount
Loans Payable	$1,500,000		Loans Receivable	$1,800,000
Less: Set Off for Seaview Ltd.	$450,000	$1,050,000	Less: Set Off for Seaview Ltd.	$450,000	$1,350,000
Shareholders' Equity		$1,500,000	Non-Current Assets		$1,200,000
		$2,550,000			$2,550,000

Bibliography:

Deegan, C. (2013). Financial accounting theory. McGraw-Hill Education Australia

Hoyle, J. B., Schaefer, T., & Doupnik, T. (2015). Advanced accounting. McGraw Hill

Towbin, P., & Weber, S. (2013). Limits of floating exchange rates: The role of foreign currency debt and import structure. Journal of Development Economics, 101, 179-194

Weil, R. L., Schipper, K., & Francis, J. (2013). Financial accounting: an introduction to concepts, methods and uses. Cengage Learning