I have a question about “take or pay” commitments which showed up on one of Schweser’s practice exams. Here is the Q: A company has a long-term “take or pay” commitment with its major supplier. When calculating the company’s financial ratios, a financial analyst should: A. Ignore the arrangement B. Add the present value of the minimum future commitment to the company’s debt only. C Add the present value of the minimum future commitment to both the company’s debt and assets. D. Subtract the present value of the minimum future commitment from the company’s debt and assets. I had chosen D because I would think that the commitment would be considered a liability and should not be added to the company’s assets. Correct answer is C, which I confirmed when researching in the book. Can anyone explain why this would be added to the company’s debt and assets instead of subtracted? Just trying to make sense of it.
plain english explanation, since u can’t back out of the contract, it’s basically a “done” deal…thus add it to both sides to make the balance sheet balance… it’s an enforceable contract, that w/out adjustment, wouldn’t show up…so u have to add it to get true sense of the bal sheet
C you are adding the present value because eventually you will be making an expenditure to obtain the underlying resource. the PV should be added to assets and equity because it a commitment to purchase a certain amount of something later in the future
Ok, that helps. Just in a habbit of thinking of a commitment to pay as a liability. A little reverse thinking helps.
C Add the present value of the minimum future commitment to both the company’s debt and assets.
rlange…oddly enough as u wrote this i was reviewing my Schweser tests… if u have Schweser…look in Exam 3 morning session…#49…great question on how it’s applied…the use of #'s might make it more understandable…