chapter 9

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Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Chapter 9

Current assets

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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.

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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

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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.

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acquire goods for

use in production, for resale or

for use in providing a service

sell goods or

service to

customers on

credit

collect cash

CASH

DEBTORS

STOCK

CREDITORSpay suppliers

who have

allowed time to pay

Working capital cycle (Continued)

Figure 9.1 The working capital cycle for a manufacturing or service business

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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.

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• 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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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Prepayments

Amounts of expenses paid in advance.

For example:

• Rental

• Insurance premiums

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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.

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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.

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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.

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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.

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Notes Year 7 Year 6

£m £m

Current assets

Inventories (stocks) 5 26.6 24.3

Receivables (debtors) 6 146.9 134.7

Short term deposits and cash

107.3 90.5

280.8 249.5

Example Safe and Sure (see text book)

Users’ needs for information

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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.

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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.

Asset acquired

+£1,000inventory (stock)

–£1,000 cash

Assets – Liabilities = Ownership Interest

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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).

End of year

− £200 expense − £200 inventory (stock)

Assets – Liabilities = Ownership interest

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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.

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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.

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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.

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Date Received Unit price Price paid Issued to production

Units £ £ units

1 June 100 20 2,000 -

20 June 50 22 1,100 -

24 June - - - 60

28 June - - - 70

Total 150 3,100 130

Basic data for illustration

Table 9.1 Pricing the issue of goods to production

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Basis Date Quantity and unit price

Issued to production

Held in inventory(stock)

Total

FIFO £ £ £

24 June 60 units at £20 1,200

28 June 40 units at £2030 units at £22

1,460

30 June 20 units at £22 440

Total 2,660 440 3,100

Valuation with changing prices

Table 9.1 Pricing the issue of goods to production (Continued)

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Basis Date Quantity and unit price



Total

LIFO £ £ £

24 June 50 units at £2210 units at £20

1,300

28 June 70 units at £20 1,400

30 June 20 units at £20 400

Total 2,700 400 3,100

Valuation with changing prices (Continued)


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Basis Date Quantity andunit price



Total

Average £ £ £

24 June 60 units at *£20.67

1,240


1,447


413

Total 2,687 413 3,100

* Weighted average [(100 x 20) + (50 x 22)] / 150 = £20.67

Valuation with changing prices (Continued)


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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.

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Importance for profit

• Assets – Liabilities = Ownership interest

• Overstating inventory (stock) values overstates profit

• Understating inventory (stock) values understates profit

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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.

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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.

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ASSETS OWNERSHIP INTEREST

Transactionor event

Rec’bls debtors

Provision for D Ds

Other assets

Ownership interest at start

Profit of the period

B/S first draft 2,000 7,000 1,800 7,200

Recognition of doubtful debts

(200) (200)

Revised B/S 2,000 (200) 7,000 1,800 7,000

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

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Presentation in Statement ofFinancial position

£

Debtor 2,000

Less Provision (200)

‘good’ debts 1,800

The ‘Provision’ is the negative part of the asset.

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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.

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Transaction or event

Rec’bles debtors

Provision for DDs

Other assets

Ownership interest at start

Profit of the period

B/S 2,500 (200) 10,000 8,800 3,500

provision no longer required

200 200

Create new provision

(350) (350)

Revised B/S 2,500 (350) 10,000 8,800 3,350

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

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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.

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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.

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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.

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Date Transaction or event Cash Prepayment

Expense

Year 2 £ £ £

Oct 1 Pay premium (1,200) (1,200)

Dec 31 Asset remaining as prepayment

900 900

(1,200) 900 (300)

Recognising the asset reduces the expense of the period from £1,200 to £300

Spreadsheet recording ofprepayment of Insurance

Table 9.5 Spreadsheet recording prepayment of insurance at the financial year-end date

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Chapter 9

Bookkeeping supplement

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DEBIT ENTRIES CREDIT ENTRIES

Left-hand side of the equation

Asset Increase Decrease

Right-hand side of the equation

Liability Decrease Increase

Ownership interest Expense Revenue

Capital withdrawn Capital contributed

Debit and credit entries in ledger accounts

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Date Debit Credit

Yr 1

End of year

Manager identifies doubtful debts £200

P&L £200

B/S Prov DD £200

Debit and credit analysis

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Date Debit Credit

Yr 2

July Customer who was doubtful pays £200 in full

Cash £200 Receivables (debtors) £200

Debit and credit analysis (Continued)

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Date Debit Credit

Yr 2

End of year

Manager identifies new provision required £350

P&L £350

Prov DD £350


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Date Debit Credit

Yr 2

End of year

Former provision no longer required

Prov DD £200

P&L £200


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L1 Receivables (debtors)

DATE PARTICULARS P DR CR BAL

Year 1 £ £ £

Dec 31 Balance at end of year 2,000

Year 2

……………… ……. …….

July Cash from customer L3 200 .........

Dec 31 Balance at end of year 2,500

Ledger accounts

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L2 Provision for doubtful debts


Year 1 £ £ £

Dec 31 P&L a/c new provision L4 200 (200)

Year 2

Dec 31 P&L a/c old provision L4 200 nil

Dec 31 P&L a/c new provision L4 350 (350)

Ledger accounts (Continued)

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L3 Cash


Year 2 £ £ £

July Cash from debtor L1 200 .........


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L4 Profit and loss account


Year 1 £ £ £

Dec 31 Balance before provision (7,200)

" Provision for DD L2 200 (7,000)

" Transfer to ownership interest L5 7,000 nil

Year 2

Dec 31 Balance before provision for doubtful debts

(3,500)

" Removal of provision no longer required

L2 200 (3,700)

" New provision for doubtful debts

L2 350 (3,350)

" Transfer to ownership interest L5 3,350 nil


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Yr2 Debit Credit

July Doubtful debt becomes bad

Provision for doubtful debts £200

Receivables (debtors) £200

July Year 2 Doubtful debt becomes bad.Provision for doubtful debts is now used to match the decrease in the asset. The analysis of the transaction would be:

No impact on the income statement (profit and loss account) of Year 2 of a bad debt which was known to be likely at the end of Year 1.

Recording a doubtful debt

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Analysis of prepayment ofinsurance, Year 1

Transaction or event Debit Credit

Yr1

Oct 1 Payment of premium £1,200 Expense (Insurance)

Cash

Dec 31

Identification of asset remaining as a prepayment £900

Asset (pre-payment)

Expense (Insurance)

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L6 Expense of insurance


Year 1 £ £ £

Oct 31 Cash L3 1,200 1,200

Dec 31 Prepayment L7 (900) 300

Dec 31 Transfer to profit and loss account

L4 (300) nil

Expense is reduced to £300 for this period

Analysis of prepayment of insurance, Year 1 (Continued)

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L7 Prepayment


Year 1 £ £ £

Oct 31 Insurance expense prepaid L6 900 900

Analysis of prepayment of insurance, Year 1 (Continued)

chapter 9

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