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Chapter 9. Current assets. Definitions. Assets are rights or other access to future economic benefits controlled by an entity as a result of past transactions or events.
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Chapter 9 Current assets
Definitions • Assets are rights or other access to future economic benefits controlled by an entity as a result of past transactions or events. • A current asset is an asset that is not intended for use on a continuing basis in the company's activities. It is an asset that has been acquired with the intention of sale, or conversion into cash, within a relatively short space of time, usually less than twelve months.
Examples • Raw materials • Work in progress • Finished goods • Trade receivables (debtors) • Amounts owed by other companies in the Group • Prepayments and accrued income • Investments held as current assets • Short-term bank deposits • Bank current account (also called 'cash at bank') • Cash in hand
Working capital cycle The working capital cycle of a business is the sequence of transactions and events, involving current assets and current liabilities, through which the business makes a profit.
acquire goods for use in production, for resale or for use in providing a service STOCK sell goods or pay CREDITORS DEBTORS suppliers service to who have customers on allowed time to pay CASH credit collect cash Working capital cycle (Continued) Figure 9.1 The working capital cycle for a manufacturing or service business
Working capital cycle (Continued) Calculated as current assets minus current liabilities. If the working capital is low, then the business has a close match between current asset and current liabilities but may risk not being able to pay its liabilities as they fall due.
Working capital cycle (Continued) • If current assets are very much greater than current liabilities, then the business has a large amount of finance tied up in the current assets when perhaps that finance would be better employed in the acquisition of more non-current (fixed) assets to expand the profit-making capacity of the operations.
Definition • Working capital is the amount of finance, which a business must provide to finance the current assets of a business, to the extent that these are not covered by current liabilities. It is calculated by deducting current liabilities from current assets.
Recognition • Inventories (stocks), receivables (debtors), investments and cash are commonly recognised in a statement of financial position (balance sheet) but element of doubt may be attached to the expectation of economic benefit and the reliability of measurement.
Inventories – finished goods • Finished goods: The future economic benefit is selling price, which exceeds the cost of purchase or manufacture. That makes a profit and increases the ownership interest but prudence dictates that profit should not be anticipated. • Finished goods are therefore measured at the cost of purchase or manufacture.
Finished goods (Continued) • Where there is strong doubt about the expected selling price, such that it might be less than the cost of purchase or manufacture, the asset of finished goods inventory (stock) is valued at the net realisable value. • Defined as the estimated proceeds from sale of the items in question, less all costs to be incurred in marketing, selling, and distributing these items.
Work in progress • Partly completed finished goods. • Risks often greater than for finished goods because of the risk of non-completion, to add to all the risks faced when the goods are completed and awaiting sale. • There is a reliable measurement, in the cost of work completed at the date of the financial statements, but careful checking is required by the managers of the business to ensure that this is a reliable measure.
Raw materials The approach to recognition is the same as that for finished goods. Raw materials are expected to create a benefit by being used in manufacture of goods for sale. On grounds of prudence the profit is not anticipated and the raw materials are recognised at the lower of cost and net realisable value.
Receivables (debtors) Debtors are persons who owe money to a business. Trade debtors are customers who buy goods on credit but have not yet paid. In the statement of financial position the trade debtors may be described as trade receivables. Other debtors • Loans made to another enterprise to help that enterprise in its activities. • Loans to employees to cover removal and relocation expenses or advances on salaries. • Refund due of overpaid tax.
Prepayments Amounts of expenses paid in advance. For example: • Rental • Insurance premiums
Recognition • Trade receivables (debtors) meet the recognition conditions because there is an expectation of benefit when the customer pays. Trade receivables (debtors) are measured at the selling price of the goods. • Profit is recognised in the income statement (profit and loss account) when the goods or services have been supplied to the customer.
Doubtful debts There is a risk that the customer will not pay. The risk of non-payment is dealt with by reducing the reported value of the asset by an estimate for doubtful debts.
Investments Held as current assets are-usually highly marketable and readily convertible into cash. Expectation of future economic benefit is therefore usually clear. Two possible measures: • Cost – prudent and reliable • Market value (called marking to market) –more relevant The approach most often used is valuation at cost.
Cash • Cash at bank (e.g. current account, instant access deposit account) or cash in hand. • The amount is known either by counting cash in hand or by looking at a statement from the bank that is holding the business bank account.
Users’ needs for information Example Safe and Sure (see text book)
Measurement – inventories Lower of cost and net realisable value Consider the example of a container of coffee beans purchased by a coffee manufacturer at a cost of £1,000. The beans are held for three months up to the date of the financial statements. During that time there is a fall in the world price of coffee beans and the container of coffee beans would sell for only £800 in the market.
Assets – Liabilities = Ownership Interest ¯ +£1,000 inventory (stock) –£1,000 cash Asset acquired When the asset is acquired, the impact on the accounting equation is an increase of £1,000 in the asset of inventory (stock) and a decrease of £1,000 in the asset of cash.
Assets – Liabilities = Ownership interest ¯ ¯ − £200 inventory (stock) − £200 expense End of year At the end of the year the asset is found to be worth £800 and the ownership interest is reduced because the asset has fallen in value. The asset is reduced by £200 and an expense of loss of inventory (stock) value is reported in the income statement (profit and loss account).
Meaning of cost • The cost of any item of inventory (stock) or work in progress is specified as the expenditure, which has to be incurred in the normal course of business in bringing the product or service to its present location and condition. • Purchase price + transport and handling + import duties – discounts – subsidies.
Cost when input prices change • Goods arrive at different times and at different unit prices. • What is the unit price to be charged to each job when all the materials look the same once they are taken into store? • Ideal solution is to label the materials as they arrive so that they can be identified with the appropriate unit price. • Often use a method that approximates to the true price of the units used.
Valuation with changing prices • First-In-First-Out (FIFO) • Assume that the goods, which arrived first are issued first. • Last-In-First-Out (LIFO) • Assume that the goods, which arrived last are issued first. • Average cost • Assume that all goods are issued at the average price of the inventory held.
Basic data for illustration Table 9.1 Pricing the issue of goods to production
Valuation with changing prices Table 9.1 Pricing the issue of goods to production (Continued)
Valuation with changing prices (Continued) Table 9.1 Pricing the issue of goods to production (Continued)
Valuation with changing prices (Continued) * Weighted average [(100 x 20) + (50 x 22)] / 150 = £20.67 Table 9.1 Pricing the issue of goods to production (Continued)
Comparison • Totals are the same at £3,100. Allocations to period are different. • FIFO matches outdated costs against current revenue. • LIFO matches the most recent costs against revenue, but the inventory (stock) value becomes increasingly out of date. • Average cost lies between the two. It is more intricate to recalculate as more items come into inventory.
Importance for profit • Assets – Liabilities = Ownership interest • Overstating inventory (stock) values overstates profit • Understating inventory (stock) values understates profit
Bad and doubtful debts • Where there is doubt about the value of an asset the directors should be invited to consider making provision against the loss of the asset. • Where it is known that the debt is bad (because the customer has declared himself/herself bankrupt) the debtor should be removed from the record as a bad debt.
Example • At the end of Year 1 the Garden Pond Company has a statement of financial position comprising £2,000 receivables (debtors), £7,000 other assets and £9,000 ownership interest, consisting of £1,800 ownership interest at the start of the period and £7,200 profit of the period. • On the date of the financial statements the manager of the company reviews the debtors list and decides that debts amounting to £200 are doubtful because there are rumours of a customer not paying other suppliers in the trade.
Spread to analyse the effects of provision for doubtful debts at the end of Year 1, using the accounting equation Table 9.2 Spreadsheet to analyse the effect of provision for doubtful debts at the end of Year 1, using the accounting equation
Presentation in Statement of Financial position The ‘Provision’ is the negative part of the asset.
Change in a provision • During Year 2 the customer who was showing signs of financial distress pays the amount of £200 owed. • At the end of Year 2 this provision for doubtful debts is now no longer required. • At the end of Year 2 the receivables (debtors) amount to £2,500. A review of the list of debtors causes considerable doubt regarding an amount of £350. • A new provision of £350 is created.
Spreadsheet to analyse thedoubtful debts Table 9.4 Spreadsheet to analyse the effect of provision for doubtful debts at the end of Year 2, using the accounting equation
Presentation The income statement (profit and loss account) could show two separate entries: • £200 increase in ownership interest. • £350 decrease in ownership interest. Most enterprises report a single line in the income statement (profit and loss account): • Increase in provision for doubtful debts of £150.
Prepayments • A common example is the payment of an insurance premium. The payment is made in advance for the year ahead and the benefit is gradually used up as the year goes along. The statement of financial position recognises the unexpired portion of the insurance premium as an asset, while the income statement (profit and loss account) reports the amount consumed during the period.
Prepayment example • On 1 October Year 1 a company paid £1,200 for one year's vehicle insurance. At the financial statement date of 31 December there have been three months' benefit used up and there is a nine-month benefit yet to come.
Spreadsheet recording of prepayment of Insurance Recognising the asset reduces the expense of the period from £1,200 to £300 Table 9.5 Spreadsheet recording prepayment of insurance at the financial year-end date
Chapter 9 Bookkeeping supplement
Ledger accounts L1 Receivables (debtors)
Ledger accounts (Continued) L2 Provision for doubtful debts
