Some waste, scrap, or by-product materials have little value. In fact, many such materials represent liabilities for companies because the materials require companies to incur significant disposal costs. Alternatively, some companies have historically found “cheap” ways to dispose of such materials. For example, between 1991 and 1994, Borden Chemicals and Plastics shipped mercury-laden-waste to Thor Chemicals’ plant at Cato Ridge, South Africa. Borden maintains that the material—spent mercuric chloride catalysts—was not hazardous waste and that it expected Thor to recycle it. According to the EPA, little or none of the material was recycled. Greenpeace says Borden’s barrels are leaking at the Thor site. Thor has settled a civil suit brought by families of employees whose exposure to the waste allegedly killed them. Greenpeace says the settlement exceeded $9 million. More litigation has ensued.

a. Comment on whether this method of disposing of industrial waste is a “cheap” alternative.

b. Discuss the ethical and legal implications of disposing of industrial waste in this manner.

c. What actions can people take to reduce these kinds of incidents?

d. Ethically, what obligation does the vendor/manufacturer of these industrial materials have to the industrial consumer of the materials?

(Process costing; joint cost allocation; by-product) Romano’s Hair Salon provides hair styling services and sells a variety of cosmetic and hair-care products. The firm also generates some revenue from the sale of hair, which is periodically swept from the floor of the styling salon. The net realizable value of hair is accounted for as a reduction in the joint cost assigned to the Styling Services and Cosmetic Products. Hair sells for $6 per pound. The cost of packaging the hair is $0.50 per pound, and selling costs of the hair are $0.30 per pound. The following information is available for 2001 on the inventory of Cosmetic Products (the firm does not produce these products; they are purchased):

Joint cost is to be allocated to Styling Services and Cosmetic Products based on approximated net realizable values (revenues less separate costs). For 2001, total revenues were $753,000 from Styling Services and $289,000 from Cosmetic Products. The following joint costs were incurred:

Separate costs were as follows:

For the year, 2,510 pounds of hair were collected and sold.

a. What is the total net realizable value of hair that is applied to reduce the joint cost assigned to Styling Services and to Cosmetic Products?

b. What is the joint cost to be allocated to Styling Services and Cosmetic Products?

c. What is the approximated pretax realizable value of each main product or service for 2001?

d. How much joint cost is allocated to each main product or service?

e. Determine the net income produced by each main product or service.

(Comprehensive) Aluma Corporation manufactures metal screen doors for commercial buildings. The standard costs per screen door follow:

Overhead rates were based on normal monthly capacity of 6,000 machine

hours. During November, 850 doors were produced. This was below normal levels due to the effects of a labor strike that occurred during union contract negotiations. Once the dispute was settled, the company scheduled overtime to try to catch up to regular production levels. The following costs were incurred in November:

Variable Overhead:

$11,700 (based on 4,175 machine hours)

Fixed Overhead: $9,300 (based on 4,175 machine hours) Determine the following:

a. Total material price variance

b. Total material usage (quantity) variance

c. Labor rate variance

d. Labor efficiency variance

e. Variable overhead spending variance

f. Variable overhead efficiency variance

g. Fixed overhead spending variance

h. Volume variance

i. Budget variance

(Four-variance approach; journal entries) Laramie Lumber produces picnic tables, swings, and benches and uses direct labor hours to apply overhead .Standard hours allowed for each product are as follows:

The standard variable overhead rate is $4 per direct labor hour; the standard fixed overhead application rate at expected annual capacity is $2 per direct labor hour. Expected capacity on a monthly basis is 3,000 direct labor hours. Production for June 2001 was 100 picnic tables, 400 swings, and 60 benches. Actual direct labor hours incurred were 3,020. Actual variable overhead was $11,900, and actual fixed overhead was $6,100 for the month.

a. Prepare a variance analysis using the four-variance approach. (Hint: Convert the production of each type of product into standard hours allowed for all work accomplished for the month.)

b. Calculate overhead variances using the four-variance method.).

c. Evaluate the effectiveness of managers in controlling costs.

Credit Risk Another important thing to remember is that with a forward contract, no money changes hands when the contract is initiated. The contract is simply an agreement to transact in the future, so there is no up-front cost to the contract. However, because a forward contract is a financial obligation, there is credit risk. When the settlement date arrives, the party on the losing end of the contract has a significant incentive to default on the agreement. As we discuss in the next section, a variation on the forward contract exists that greatly diminishes this risk.

Where are forward contracts commonly used to hedge? Because exchange rate fluctuations can have disastrous consequences for firms that have significant import or export operations, forward contracts are routinely used by such firms to hedge exchange rate risk. For example, Jaguar, the U.K. auto manufacturer (and subsidiary of Ford Motor Co.), historically hedged the U.S. dollar–British pound exchange rate for six months into the future.

CONCEPT QUESTIONS

a What is a forward contract? Describe the payoff profiles for the buyer and the seller of a forward contract.

b Explain how a firm can alter its risk profile using forward contracts.

Interest Rate Swaps: An Example

To get a better understanding of swap contracts and the role of the swap dealer, we consider a floating-for-fixed interest rate swap. Suppose Company A can borrow at a floating rate equal to prime plus 1 percent or at a fixed rate of 10 percent. Company B can borrow at a floating rate of prime plus 2 percent or at a fixed rate of 9.5 percent. Company A desires a fixed-rate loan, whereas Company B desires a floating-rate loan. Clearly, a swap is in order. Company A contacts a swap dealer, and a deal is struck. Company A borrows the money at a rate of prime plus 1 percent. The swap dealer agrees to cover the loan payments, and, in exchange, the company agrees to make fixed-rate payments to the swap dealer at a rate of, say, 9.75 percent. Notice that the swap dealer is making floating-rate payments and receiving fixed-rate payments. The company is making fixed-rate payments, so it has swapped a floating payment for a fixed one.

Company B also contacts a swap dealer. The deal here calls for Company B to borrow the money at a fixed rate of 9.5 percent. The swap dealer agrees to cover the fixed loan payments, and the company agrees to make floating-rate payments to the swap dealer at a rate of prime plus, say, 1.5 percent. In this second arrangement, the swap dealer is making fixed-rate payments and receiving floating-rate payments. What’s the net effect of these machinations? First, Company A gets a fixed-rate loan at a rate of 9.75 percent, which is cheaper than the 10 percent rate it can obtain on its own. Second, Company B gets a floating-rate loan at prime plus 1.5 instead of prime plus 2. The swap benefits both companies.

The swap dealer also wins. When all the dust settles, the swap dealer receives (from Company A) fixed-rate payments at a rate of 9.75 percent and makes fixed-rate payments (for Company B) at a rate of 9.5 percent. At the same time, it makes floating-rate payments (for Company A) at a rate of prime plus 1 percent and receives floating-rate payments at a rate of prime plus 1.5 percent (from Company B). Notice that the swap dealer’s book is perfectly balanced, in terms of risk, and it has no exposure to interest rate volatility.

Notice that the essence of the swap transactions is that one company swaps a fixed payment for a floating payment, while the other exchanges a floating payment for a fixed one. The swap dealer acts as an intermediary and profits from the spread between the rates it charges and the rates it receives.

CONCEPT QUESTIONS

a What is a swap contract? Describe three types.

b Describe the role of the swap dealer.

c Explain the cash flows .

American Depository Receipts

Nestlé S. A. has American Depository Receipts listed on the Nasdaq over-the-counter market. Many ADRs listed on U.S. exchanges are for fractional shares. In the case of Nestlé, 20 ADRs are equal to one registered share of stock. Find the information for Nestlé using the ticker symbol “3NSRGY.”

a. Click on the “Mthly. Adj. Prices” link and find Nestlé’s closing price for August 2001. Assume the exchange rate on that day was $/SFr 1.624 and Nestlé shares traded for SFr 630. Is there an arbitrage opportunity available? If so, how would you take advantage of it?

b. What exchange rate is necessary to eliminate the arbitrage opportunity available in a?

c. Dividend payments made to ADR shareholders are in U.S. dollars. Suppose you own 90 Nestlé ADRs. Assume the current exchange rate is the rate you calculated in b. Nestlé declares a dividend of SFr 5.20. What U.S. dollar dividend payment will you receive?

Hedging Long-Term Exposure

Price fluctuations can also be longer-run, more permanent changes. These result from fundamental shifts in the underlying economics of a business. If improvements in agricultural technology come about, for example, then wheat prices will permanently decline (in the absence of agricultural price subsidies!). If a firm is unable to adapt to the new technology, then it will not be economically viable over the long run.

A firm’s exposure to long-run financial risks is often called its economic exposure. Because long-term exposure is rooted in fundamental economic forces, it is much more difficult, if not impossible, to hedge on a permanent basis. For example, is it possible that a wheat farmer and a food processor could permanently eliminate exposure to wheat price fluctuations by agreeing on a fixed price forever?

The answer is no, and, in fact, the effect of such an agreement might even be the opposite of the one desired. The reason is that if, over the long run, wheat prices were to change on a permanent basis, one party to this agreement would ultimately be unable to honor it. Either the buyer would be paying too much, or the seller would be receiving too little. In either case, the loser would become uncompetitive and fail. Something of the sort happened in the 1970s when public utilities and other energy consumers entered into long-run contracts with natural gas producers. Natural gas prices plummeted in later years, and a great deal of turmoil followed.

In the long run, either a business is economically viable or it will fail. No amount of hedging can change this simple fact. Nonetheless, by hedging over the near term, a firm gives itself time to adjust its operations and thereby adapt to new conditions without expensive disruptions. So, drawing our discussion in this section together, we can say that, by managing financial risks, the firm can accomplish two important things. The first is that the firm insulates itself from otherwise troublesome transitory price fluctuations. The second is that the firm gives itself a little breathing room to adapt to fundamental changes in market conditions.

CONCEPT QUESTIONS

a What is a risk profile? Describe the risk profiles with regard to oil prices for an oil producer and a gasoline retailer.

b What can a firm accomplish by hedging financial risk?

(Direct material and direct labor variances) Lisa Scamponi Ltd. Produces evening bags. In December 2001, Ms. Scamponi, president of the company, received the following information from Antonio Buffa, the new controller, in regard to November production:

Ms. Scamponi asked Mr. Buffa to provide her with the following specific information:

a. The standard quantity of material allowed for November production

b. The standard direct labor hours allowed for November production

c. The material price variance

d. The labor efficiency variance

e. The standard prime (direct material and direct labor) cost to produce one bag

f. The actual cost to produce one bag in November

g. An explanation for the difference between standard and actual cost. Be sure the explanation is consistent with the pattern of the variances.

You are the chief accountant of Britain plc. Britain plc has a number of subsidiaries located in various parts of the world. One of these subsidiaries is Faraway Ltd. Faraway Ltd prepares its financial statements in accordance with local Accounting Standards. The accountant of Faraway Ltd has prepared the financial statements for the year ended 30 September 2001 – also the accounting reference date of Britain plc. The profit and loss account for the year ended 30 September 2001 (together with comparatives) drawn up in loca1 currency (LC) was as shown below.

The local Accounting Standards that are used in preparing the financial statements of Faraway Ltd are the same as UK Accounting Standards with the exception of the following:

1. Faraway Ltd values its stocks using the LIFO basis. This valuation is acceptable for local tax purposes. Relevant stock values are as follows:

The stock levels of Faraway Ltd often vary from year to year and prices do not rise

evenly. The rate of local corporate taxation is 36%.

1. On 1 October 1993, Faraway Ltd acquired an unincorporated business for 50 million units of local currency. The fair value of the net assets of this business on 1 October 1993 was 30 million units of local currency. The resulting goodwill was written off to the profit and loss reserve as permitted by local Accounting Standards. At the date of acquisition, the directors of Faraway Ltd ascertained that the useful economic life of this goodwill was 10 years.

The accountant of Faraway Ltd has sent the financial statements to you with a suggestion that consolidation would be much easier if all group companies used International Accounting Standards to prepare their individual financial statements.

Required

(a) Restate the profit and loss account of Faraway Ltd in local currency (both the current year and the comparative) so as to comply with UK Accounting Standards.

(b) Evaluate the practicality of the suggestion that all group companies should use International Accounting Standards.