Transcript ACCOUNTING THEORY: TEXT AND READINGS

CHAPTER 8
WORKING
CAPITAL
Working Capital
Net short-term investment needed to carry on
day-to-day activities
Computed
Minus
Current Assets
Current Liabilities
Working Capital Issues
1. Inconsistencies in the measurements
of its components
2. Differences of opinion over
what should be included as
the elements
3. Lack of precision in defining the
elements
 particularly with respect to the terms “liquidity”
and “current”
Purpose of the
Chapter
1 Examine the foundation of the
working capital concept
2 Review the concept and its
components as currently
understood
3 Illustrate how the adequacy of a
company’s working capital can be
evaluated
4 Discuss possible modifications
Development of the Working
Capital Concept
Fixed vs. circulating capital
The double-account system
Creditor vs. investor point of view
Liquidity as the basis for asset
classification on the balance sheet
Will be vs. could be
Anson Herrick and ARB No. 3 - the operating
cycle
Current usage - indication of liquidity and
degree of protection to short-term creditors
Components of Working
Capital
ARB No. 43
Definition of working capital
Examples of current assets and current
liabilities
Current Assets
Cash
Cash equivalents
Current Assets
Temporary investments
Alternative methods
Historical cost
Fair value
Lower of cost or market
SFAS No. 12
Why adopted
Problems with
SFAS No. 12
Temporary investments
under SFAS No. 115
Trading securities
Available-for-sale securities
Held-to- maturity securities
Transfer between categories
Current Assets
Receivables
Bad debts
SFAS No. 114
Inventories
Inventory quantity
Flow assumption
Market fluctuations
Prepaids
Current Liabilities
Current
Maturities
Payables
Deferrals
Financial Analysis of a Company’s
Working Capital Position
How do liquidity
problems occur?
Evaluate with ratio
analysis
Working Capital
Current Assets
Problems with its use
Current Liabilities
Current Ratio
Current assets
Current liabilities
Acid Test (Quick) Ratio
Cash + Marketable Securities + Receivables
Current liabilities
Cash Flow from Operations
to Current Liabilities
Net cash provided from operating activities
Average current liabilities
Receivables
Accounts receivable turnover ratio
Net Credit Sales
Average Accounts Receivable
Days in receivables
365
Accounts Receivable Turnover Ratio
Inventory
Inventory turnover ratio
Cost of Goods Sold
Average Inventory
Average days in inventory
365
Inventory Turnover Ratio
Accounts Payable
Accounts payable turnover ratio
Inventory Purchases
Average Accounts Payable
Average days payables outstanding
365
Accounts Payable Turnover Ratio
Summary of Best Buy’s
Working Capital Position
1. Accounts receivable are paid in
approximately 5 days.
2. Inventory remains on hand for
approximately 46 days.
3. Current operations are not generating
sufficient cash to repay current liabilities.
4. Accounts payable are being satisfied in
approximately 51 days.
Summary of Circuit City’s
Working Capital Position
1. Accounts receivable are paid in
approximately 7 days.
2. Inventory remains on hand for
approximately 63 days.
3. Current operations are not generating
sufficient cash to repay current
liabilities.
4. Accounts payable are being satisfied in
approximately 47 days.
Modification of the
Working Capital Concept
Much of the foundation for the concept is
based on customs and conventions
Current practice
assumes that items classified as
current assets will be used to pay
current liabilities
flawed because:
All items are not measured by their
current cash equivalents
Some of the items will not be received or
paid in cash
International
Accounting Standards
The IASC has issued
pronouncements on the
following issues affecting
working capital:
1 Revised IAS No. 1, “Presentation of
Financial Statements”
 presentation of current assets and
current liabilities
2 IAS No. 25, “Accounting for
Investments”
 accounting for and disclosure of
investment securities in
3 IAS No. 2 , “Inventories”
IAS No. 1
The IASC did not attempt to deal with the
valuation issues discussed earlier in the
chapter
Discussed two views of current assets and current
liabilities:
1
2
A measure of liquidity
Identification of circulating resources and obligations
Since these views are contradictory, it has lead to
classifications of items by convention
Allows, but does not require, companies to decide
whether or not to sub-classify assets and liabilities as
current
FASB staff review indicated that it was quite similar to
U. S. GAAP
IAS No. 25
Allows investments classified as current to be
accounted for by market value or LCM
Value may be determined individually, by
investment category, or on a total portfolio
basis
Preference for the total portfolio or
investment category methods
No review by FASB staff because topic was
under reconsideration by both FASB and
IASC at the time of the review
IAS No. 2
Objective of inventory reporting is to determine proper
amount of cost to recognize as an asset
Specific identification method preferred
If not feasible, FIFO or weighted average preferred
LIFO is an allowable alternative
If LIFO is used, must disclose lower of cost
and net realizable value
FASB staff indicated that requirements were
similar to U.S. GAAP
wide range of alternatives and lack of adequate
disclosure requirements in both make
intercompany comparisons virtually
impossible
Prepared by
Richard Schroeder, DBA
Kathryn Yarbrough, MBA
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