take or pay contracts

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nikko0355

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i think i understand what they are..
the buyer pays some money up front and if the contract/product is not delivered i lose my money.
now from the firms point of view. if i have these types of contracts outstanding they are a benefit to me right. b/c if i cant deliever on the product i still get some money. does this mean i have more assets?
An analyst suspects that a particular company’s U.S. GAAP financial statements may require adjustment because the company uses take-or-pay contracts. The most likely effect of the appropriate adjustments would be to increase that company’s
A. return on assets.
B. debt-to-equity ratio.
C. interest coverage ratio.
D. return on common equity.
i found this question on the cfai website and dont know the answer..
 
I guess they are talking about purchasing company. That means the company is committed to purchasing on take-or-pay contract.
For adjustment, debt and asset should be increased by the present value of commitments:
a. Return on assets: Since assets increase, ROA should be downward adjusted
b. D/E ratio: Debt increase will lead to upward adjustment of D/E ratio
c. Interest coverage ratio: adjusted downward since EBIT is now lower due to the debt commitments
d. Return on equity: Net income decreases hence ROE is lower
==> B is the only upward adjustment.
 
Is take or pay adjustment exactly same as operating lease and capital lease adjustment? It seems answer is yes.
 
i know the basic balance sheet equation….
i was looking for a different answer…
if i am committed to purchasing on a take or pay contract how do i consider thi s an asset if i know that there is a chance i end up paying and getting nothing
 
LOS 10.46.c.2:
“Since the debt on take-or-pay contracts and throughput arrangements is off-balance sheet, it lowers leverage ratios such as the debt ratio and the D/E ratio. For analytical purposes, the present value of the debt obligations should be added back to long-term liabilities and assets to restate the debt values”
 
I don’t understand this very well either, particularly why Debt is increased upward.
My understanding is a take or pay contract is an obligation to buy a certain quantity of product over a certain period of time. Eg. I must buy 2000 bushels of wheat in 2007 at price X.
If I were to make an adjust, I would have thought, that I would simulataneously debit my Wheat inventory asset by 2000X, and credit my Accounts Payable liability by the same amount.
Does this mean that debt includes accounts payable, or does the accounting treatment work a different way? Specifically, how does debt, or what component of debt, (notes payable, long term debt, etc..) gets adjusted upwards?
 
Nevermind I just found the answer.. Accounts payable is part of Total Debt.
so it makes sense.. assets and liabilities (debt) both increase, which raises the Debt-Equity ratio, but not the ROA.
Edit (there’s still a problem): Debt to Equity ratio is based on long term debt, so if the adjustment is made only for the current period, ie the take or pay contract is valid for only a year, then only short term Debt should get adjusted, therefore Debt to Equity doesn’t increase..?
 
Nevermind once again.. the question states “most likely”, so increasing the Debt Equity would be the most likely outcome.
(I must be frazzled today.. )
 
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