Understanding Current Assets: Inventories, Receivables, Investments, and Cash, Guide, Progetti e Ricerche di Economia Aziendale

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COURSEWORK ACCOUNTING

CURRENT ASSETS

1.1 Introduction 1.2 Definitions 1.3 The working capital cycle 1.4 Recognition 1.4.1 Inventories (stocks) 1.4.2 Receivables (debtors) and prepayments 1.4.3 Investments 1.4.4 Cash 1.5 Users’ needs for information 1.6 Information provided in the financial statements 1.6.1 Details in notes 1.6.2 Accounting policy 1.6.3 Operating and financial review 1.7 Measurement and recording 1.8 Inventories (stocks) of raw materials and finished goods 1.8.1 Lower of cost and net realisable value 1.8.2 Meaning of cost 1.8.3 Costs when input prices are changing 1.8.4 Approximation when dates are not recorded 1.8.5 Choice of FIFO, LIFO or average cost 1.9 Receivables (debtors) 1.9.1 Change in a provision

1.1 INTRODUCTION

An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow. A current asset is an asset that satisfies any of the following criteria: (a) it is expected to be realised in, or is intended for sale or consumption in, the entity’s normal operating cycle; (b) it is held primarily for the purpose of being traded; (c) it is expected to be realised within twelve months after the balance sheet date; (d) it is cash or a cash equivalent. The following list is a sample of the current assets found in most company balance sheets:

1. raw materials
2. work-in-progress l finished goods
3. trade receivables (debtors)
4. amounts owed by other companies in a group
5. prepayments and accrued income
6. investments held as current assets
7. short-term bank deposits
8. bank current account (also called ‘cash at bank’)
9. cash in hand.

1.2 The definition of a current asset refers to ‘the entity’s normal operating cycle’. The operating cycle experienced by many businesses lasts for 12 months, covering all the seasons of one year. One year is the reporting period most commonly used by most enterprises for reporting to external users of financial statements. 1.3 THE WORKING CAPITAL CYCLE Working capital is the amount of long-term finance the business has to provide in order to keep current assets working for the business. Some short-term finance for current assets is provided by the suppliers who give credit by allowing time to pay, but that is not usually sufficient. Some short-term finance for current assets is provided by short-term bank loans but, in most cases, there still remains an excess of current assets over current liabilities. 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. Exhibit 1.1 shows how the working capital cycle begins when suppliers allow the business to obtain goods on credit terms, but do not insist on immediate payment. While they are waiting for payment, they are called trade creditors. The amounts owing to suppliers as creditors are called trade payables in the balance sheet. The goods obtained by the business are used in production, held for resale or used in providing a service. While the goods acquired are held by the business, they are called the inventories (stocks) of the business. Any products manufactured from these goods and held for resale are also part of the

employed in the acquisition of more fixed assets to expand the profit-making capacity of the operations. 1.4 Inventories (stocks) ‘Inventories’ means lists of items. You might come across an inventory if you rent a flat and the owner has a list of the contents that is checked at the start and end of your tenancy. Definition Inventories are assets: (a) held for sale in the ordinary course of business; (b) in the process of production for sale; (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services. If a company is presenting its financial statements using the IASB’s accounting system you will probably see the description ‘inventories’. If the company is following UK company law and UK ASB standards then you will probably see the description ‘stocks’. The remainder of this chapter explains the IASB’s system for reporting inventories. The rules of UK law and standards are very similar. In business entities there are three main categories of inventories: raw materials, work-in-progress and finished goods. Consider these in reverse order. Finished goods The future economic benefit expected from finished goods is that they will be sold to customers for a price which exceeds the cost of purchase or manufacture. That makes a profit which increases the ownership interest. However, until

the sale is agreed with the customer, this expected benefit is uncertain and the qualitative characteristic of prudence dictates that it is safer not to anticipate that the profit will arise. The value of the inventories of finished goods is therefore measured at the cost of purchase or manufacture. In most cases that is a reliable measure because it is based on recorded costs and is not anticipating an uncertain selling price. Sometimes there may be a disappointment where goods are manufactured and then it is found there is a lack of demand. Where there is strong doubt about the expected selling price, such that it might be less than the cost of purchase or manufacture, the inventories (stock) of finished goods are valued at the net realisable value. This is 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. The accounting policy note of most companies confirms this prudent approach. The expected future benefit of that activity is gradually building up as the work moves towards completion. A business could wait until the asset is totally finished, before recognising the asset in the balance sheet. That would satisfy the qualitative characteristic of prudence, supported by the characteristic of reliability, but would run into problems with the characteristic of relevance. Where work-in-progress is a substantial aspect of the operations of the business, users need to know how much work- in-progress there is, whether it is increasing or decreasing, and what risks are attached. The risks attached to work-in-progress are often greater than those attached to finished goods because

enterprise to help that enterprise in its activities. There may be loans to employees to cover removal and relocation expenses or advances on salaries. The business may be due to receive a refund of overpaid tax. Trade receivables (debtors) meet the recognition conditions because there is an expectation of benefit when the customer pays. The profit on the sale of the goods is known because the customer has taken the goods or service and agreed the price. Trade receivables (debtors) are therefore measured at the selling price of the goods and the profit is recognised in the income statement (profit and loss account). There is a risk that the customer will not pay, but the view taken is that the risk of non-payment should be seen quite separately from the risk of not making a profit on a sale. The risk of non-payment is dealt with by reducing the reported value of the asset using an estimate for doubtful debts. That process is explained later in the chapter. Prepayments are amounts of expenses paid in advance. Insurance premiums, rent of buildings, lease charges on a vehicle, road fund licences for the delivery vans and lorries, are all examples of items which have to be paid for in advance. At the balance sheet date some part of the future benefit may remain. This is recognised as the prepayment. -An example of an insurance premium of £240 paid on 1 October to cover a 12-month period. At the company’s year-end of 31 December, three months’ benefit has expired but nine months’ benefit remains. The balance sheet therefore reports a prepayment of £180.

Definition of prepayment : an amount paid for in advance for an benefit to the business, such as insurance premiums or rent in advance. Initially recognised as an asset, then transferred to expense in the period when the benefit is enjoyed. Investments: held as current assets are usually highly marketable and readily convertible into cash. The expectation of future economic benefit is therefore usually sufficient to meet the conditions of recognition. There are two possible measures. One is the cost of the investment and the other is the market value. Recognising the investment at cost is prudent and reliable, but not as relevant as the current market value which is the amount of cash that could be released by sale of the investment. There is no agreed answer to this problem at the present time, although the issue has been debated in the standard-setting context. Most businesses report current asset investments at cost but a smaller number use the market value. Using the market value is called marking to market. It is a departure from the normal practice of recording assets at original cost but is justified in terms of the requirement of company law that financial statements should show a true and fair view. It is seen in companies whose business involves dealing in investments. Cash is no problem either in the expectation of benefit or in the measurement of the asset. The amount is known either by counting cash in hand or by looking at a statement from the bank which is holding the business bank account. The expectation of

of the business and how it is managed. The concern of creditors and employees is primarily with the flow of cash and its availability on the day required. That information will not appear in the balance sheet but there will be some indications of flow in the cash flow statement. 1.6 The balance sheet contained three lines relating to current assets: CURRENT ASSETS

NOTE

S

YEAR

YEAR

Inventories (stocks) Amounts receivable (debtors) Six-month deposits Cash and cash equivalent

There is more information provided in the notes to the balance sheet. There are two relevant notes, of which note 5 deals with inventories and note 6 with receivables (debtors): INVENTORIES (STOCKS) YEAR 1 YEAR 2 RAW MATERIALS 6.2 5. WORK-IN- PROGRESS 1.9 1. FINISHED 18.5 17.

PRODUCTS 26.6 24. This company is a service company so it is not surprising that stocks do not figure prominently in the overall collection of current assets. It is perhaps more surprising that there are inventories of finished products, but reading the description of the business shows that there is a Products Division which manufactures special cleaning chemicals under the company name. The note on receivables (debtors) shows that the main category is trade receivables (debtors): AMOUNTS RECEIVABLE (DEBTORS)

YEAR 1 YEAR 2

TRADE

RECEIVABLES

OTHER

RECEIVABLES

PREPAYMENTS

AND ACCURED

INCOME

Definition Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. This section covers first of all the accounting equation in relation to the rule. It then looks at the meaning of cost and the allocation of overhead costs. Various specific models to deal with changing input prices are then discussed and the section concludes with the rules to be applied in financial reporting. 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 balance sheet date. 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. When the asset is acquired, the impact on the accounting equation is an increase of £1,000 in the asset of inventories and a decrease of £1,000 in the asset of cash. 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 value in inventories value is reported in the income statement (profit and loss account. If a business fails to report a fall in the value of the asset of inventories, the profit of the period will be overstated. Where there are separate categories of inventories the rule of ‘lower of cost and net realisable value’ must be applied to each category separately. Suppose, for example, there is an inventory (stock) of paper at a cost of £2,000 with a net

realisable value of £2,300 and an inventory (stock) of pens with a cost of £1,800 and a net realisable value of £1,400. The lower amount must be taken in each case, giving a value of £3,400 for inventories (calculated as £2,000 plus £1,400). The cost of inventories comprises all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. This expenditure will include not only the cost of purchase but also costs of converting raw materials into finished goods or services. Costs of purchase include the price charged by the supplier, plus transport and handling costs, plus import duties, and less discounts and subsidies. Costs of conversion include items readily identifiable with the product, such as labour, expenses and subcontractors’ costs directly related to the product. They also include production overheads and any other overheads directly related to bringing the product or service to its present condition and location. Production overheads are items such as depreciation of machines, service costs, rental paid for a factory, wages paid to supervisory and support staff, costs of stores control and insurance of production facilities. Another problem faced by the accounts department in its record keeping is that suppliers change their prices from time to time. Goods held in store may have arrived at different times and at different unit prices. How does the accounts department decide on the unit price to be charged to each job when all the materials look the same once they are taken into store?

cost Assume that all goods are issued at the average price of the inventories held. BASI S

DAT

E

QUANTIT

Y AND

UNIT

PRICE

ISSUED TO

PRODUCTIO

N

HELD IN

INVENTORI

ES

TOTA

L

FIFO

24 JUNE 60 UNITS

AT £

28 JUNE 40 UNITS

AT £

30 UNITS

AT £

30 JUNE 20 UNITS

AT £

TOTAL 2660 440 3100

LIFO

24 JUNE 50 UNITS

AT £

10 UNITS

AT £

28 JUNE 70 UNITS

AT £

30 JUNE 20 UNITS

AT £

TOTAL 2700 400 3100

AVERAG

E

24 JUNE 60 UNITS

AT

28 JUNE 70 UNITS

AT

30 JUNE 0 UNITS

AT

TOTAL 2687 413 3100

Look at table (c) and compare it with table (a) of that exhibit. You will see from table (a) that the total amount spent on materials during the month was £3,100. You will see from table (c) that the total of the cost of goods issued to production, plus the cost of unsold goods, is always £3,100 irrespective of which approach is taken. All that differs is the allocation between goods used in production and goods remaining unsold. Cost can never be gained or lost in total because of a particular allocation process, provided the process is used consistently over time. The FIFO approach suffers the disadvantage of matching outdated costs against current revenue. The LIFO approach improves on FIFO by matching the most recent costs against revenue, but at the