Working Capital and Its Components Flashcards
Working capital
= Current assets - Current liabilities
A measure of solvency of a company
Current ratio
Current assets / Current liabilities
Quick ratio
(Cash + Net receivables + Marketable securities) / Current liabilities
Basically… (Current assets - Inventory) / Current liabilities
For working capital financial ratios, what does a higher ratio mean?
Lower risk
Current assets
Those resources that are reasonably expected to be realized in cash, sold, or consumed (prepaid items) during the normal operating cycle of a business or one year, whichever is longer
When would the cash surrender value of life insurance be a current asset?
If the policy owner intends to surrender the policy for its cash surrender value during normal operating cycle
Current liabilities
Obligations whose liquidation is reasonably expected to require the use of current assets or the creation of other current liabilities
Under US GAAP, when would ST obligations be excluded from current liabilities and included in noncurrent liabilities?
If the company INTENDS to refinance it on a LT basis and the intent is supported by the ABILITY to do so as evidenced either by:
- The actual refinancing prior to the issuance of the FS, or
- The existence of a noncancelable financing agreement from a lender having the financial resources to accomplish the refinancing
Under IFRS, what are ST obligations expected to be refinanced on a LT basis classified as?
Current liabilities (must wait until it actually happens to classify as noncurrent)
What are ST, highly liquid investments?
Investments that have an original maturity of 90 days that are readily convertible to cash
Present significant risk of changes in value
When are deposits held as compensating balances against borrowing arrangements with lending institutions considered a cash equivalent?
When it is NOT legally restricted
Restricted cash
Cash that has been set aside for a specific use or purpose
NET of restrictions should be disclosed in footnotes
Unrestricted cash
Used for all current operations
How do you classify the restricted cash?
- Associated with current asset/current liability => classify as current asset but separate from unrestricted cash
- Associated with noncurrent asset/noncurrent liability => classify as noncurrent asset but separate from Investments and Other assets
What are the two forms of bank reconciliations?
- Simple reconciliation
2. Reconciliation of cash receipts and disbursements
Simple reconciliation
Goal: Calculate “true balance”
Differences between the cash balance reported by the bank and the cash balance per the depositor’s records are explained
How are the following handled in a simple reconciliation: 1. Deposits in transit 2. Outstanding checks 3. Service charge 4. Bank collections 5. Errors 6. Non-sufficient funds (NSF) 7 Interest income
- Deposits in transit — Add to bank
- Outstanding checks — Subtract from bank
- Service charge — Subtract from books
- Bank collections — Add to books
- Errors — Correct appropriately
- Non-sufficient funds (NSF) — Subtract from books
7 Interest income — Add to books
What are the procedures for a simple bank reconciliation?
- Book balance is adjusted to reflect any corrections reported by the bank
- After adjustments are made => Adjusted Book Balance = True Balance
- Bank balance per bank statement is reconciled to the “true balance”
Reconciliation of cash receipts and disbursements
Four-column reconciliation (Proof of cash)
Serves as proof of the proper recording of cash transactions
Reconciles any differences between the amount the depositor has recorded as cash receipts and the amount the bank has recorded as deposits; and the differences between amounts the depositor has recorded as cash disbursements and amounts the bank has recorded as checks paid
Accounts receivable
Oral promises to pay debts and are generally classified as current assets
Classified as either trade receivables or non-trade receivables
What increases A/R and what decreases it?
Increase: Credit sales
Decrease: Write-offs, Convert to note, Cash collected
Blank analysis format
Tool that is merely an “add-subtract” form of a “T” account (BASE)
Net realizable value of accounts receivable
Balance of the accounts receivable account adjusted for allowances for receivables that may be uncollectible, sales discounts, and sales returns and allowances
Discounts (Speed)
Offer of a cash discount on payments made w/in a specified period
Encourages prompt payment
What are the two types of discounts?
- Sales/cash discounts
2. Trade discounts
How are sales/cash discounts accounted for?
Either net or gross
Sales/cash discount
Based on a percentage of the sales price (2/10, n/30)
Gross method for sales/cash discounts
Records sale w/out regard to available discount
J/E:
Sale:
Dr. A/R 100
Cr. Sales 100
Payment received w/in discount pd:
Dr. Cash 98
Dr. Sales discount taken 2
Cr. A/R 100
Net method for sales/cash discounts
Records sales and A/R net of available discounts
J/E:
Sale:
Dr. A/R 98
Cr. Sales 98
Payment not received w/in discount pd:
Dr. Cash 100
Cr. A/R 98
Cr. Sales discount not taken 2
How are trade discounts reported?
Sales revenues and A/R recorded NET of trade discounts
Applied sequentially
Trade discounts
Quantity discounts
What is the general rule for accounting for sales returns and allowances?
GR: Wait to record sales returns and allowances until it actually happens
EXPECTED exchanges do not affect sales, inventory, or COGS
When would you estimate and accrue sales returns and allowances?
When past experience shows that a material percentage of receivables are returned
J/E to record sales return
Dr. Sales return and allowances (contra sales)
Cr. A/R
How should A/R be presented on the B/S?
At net realizable value (NRV)
What are the two methods of recognizing uncollectible A/R?
- Direct write-off method
2. Allowance method
Which method of recognizing uncollectible A/R is acceptable for GAAP and why?
The allowance method because it is consistent with accrual accounting
Direct write-off method
The account is written off and the bad debt is recognized when the account becomes uncollectible
Used for federal income tax purposes (“wait actual”)
Not GAAP (not accrual basis)
What is another weakness of the direct write-off method?
A/R are always overstated b/c no attempt made to account for the unknown bad debts included in balance on FS
Allowance method
Allowance for uncollectibles based on past experience. Percentage of each period’s sales or ending A/R is estimated to be uncollectible => amount determined is charged to bad debts of the period and the credit is made “allowance for uncollectible accounts”
GAAP
Goal: Estimate and book now (matching)
What are the three generally accepted methods of estimating uncollectible or doubtful accounts under the allowance method?
- Percentage of sales method (IS approach)
- Percentage of A/R at YE method (BS approach)
- Aging of receivables method (BS approach)
Percentage of sales method
Percentage of each sale is debited to “bad debt expense” and credited to “allow. for doubtful accounts” (% based on co. experience)
Emphasizes matching
Percentage of A/R at YE method
Uncollectible accounts estimated as certain percentage of A/R at year-end
*Under this method, the amount of estimated allow. calculated is the ending balance that should be in the allow. for doubtful accounts on BS
Aging of receivables method
Schedule is prepared categorizing accounts by the # of days or months outstanding => each category’s total dollar amount is then multiplied by a % representing uncollectibility based on past experience
The sum of the product for each aging category will be the desired ending balance in allow. account
Emphasizes asset valuation NRV
What is included in the amount charged to earnings for bad debt expense of the period?
- Provision made during the period
2. Adjustment made at YE to increase/decrease the balance in the allow. for uncollectible accounts, if needed
J/E to write-off specific A/R
Dr. Allowance for doubtful accounts
Cr. A/R
No effect on I/S
B/S affected only in form, not in total
Under the direct write-off method, how is a collection on a receivable previously written off accounted for (J/E)?
Dr. Cash
Cr. Uncollectible accounts recovered (rev. account)
Under the allowance method, how is a collection on a receivable previously written off accounted for (J/E)?
Reverse w/o (increase a/r):
Dr. A/R
Cr. Allowance for uncollectible accounts
Record cash collection (decrease a/r):
Dr. Cash
Cr. A/R
What increases and decreases allowance for uncollectible accounts?
Increase (Credit): Recovery of account written off, current year bad debt expense
Decrease (Debit): Write-offs
Pledging (Assignment)
The process whereby the company uses existing A/R as collateral for a loan
Title retained but pledges it will use proceeds to pay loan
How is pledging accounted for?
Footnote
Dr. Cash
Cr. N/P
Factoring of A/R
Process by which a company can convert its receivables into cash by assigning them to a “factor” either without or with recourse
Factoring without recourse
The sale is final (true sale) and the assignee (the factor) assumes the risk of any losses on collections
J/E to factor A/R w/out recourse
Dr. Cash
Dr. Due from factor (factor’s margin)
Dr. Loss on sale of receivable
Cr. A/R
“Due from facor”
Proceeds retained by the factor (security for the factor)
Factoring with recourse
The factor has an option to re-sell any uncollectible receivables back to seller (sale or loan with a/r as collateral)
In order for factoring with recourse to be considered a sale, what conditions must the transfer meet?
All of the following:
- Transferor’s (seller’s) obligation for uncollectible accounts can reasonable be estimated (post some security => “due from”)
- Transferor surrenders control of the future economic benefits of the rec’v to the buyer
- Transferor cannot be required to repurchase the rec’v, but may be required to replace the rec’v w/other similar rec’v
Financial-components approach
Basis for the GAAP rules for transfers and servicing of financial assets
Focuses on control
Financial assets and liabilities may be divided into many components, which may have different accounting methods applied to them
What conditions must be met before control is considered to be surrendered?
All of the following:
- Transferred assets have been isolated from transferor
- Transferee has right to pledge/exchange the assets
- Transferor does not maintain control over transferred assets under repurchase agreement
How is the transfer of financial assets recorded if there is surrender of control and no continuing involvement?
Recorded as a sale, with reduction in rec’v and recognition of g/l
How is the transfer of financial assets recorded if there is surrender of control and continuing involvement?
Recorded as a sale using the financial-components approach with transferred assets divided b/w “sold” and “not sold”, and resulting g/l recorded for those sold
How is the transfer of financial assets recorded if no control is surrendered?
Transferee and transferor will account for transfer as secure borrowing w/ pledged collateral and will recognize appropriate asset/liability amounts and interest rev/exp amounts
Notes receivable
WRITTEN promises to pay a debt (writing = promissory note)
Can be current asset or LT asset
How are notes receivable valued
At PV of FCF (unearned interest and finance charges are deducted from the face amount of the note
If non-interest bearing or interest rate below mkt, value determined by imputing mkt rate of interest and using effective interest method
Discounting notes receivable (get cash now)
Arise when the holder endorses the not (with or w/out recourse) to 3rd party and receives sum of cash. Amount received by holder is determined by applying “discount rate” to maturity value of note
Discounting N/R with recourse
Holder remains contingently liable for ultimate payment of the note when becomes due
Reported on B/S w/corresponding contra account or N/R removed and contingent liability disclosed in the notes
J/E to record discount N/R with recourse
Dr. Cash
Cr. N/R discounted (contra asset)
OR
Dr. Cash
Cr. N/R
Discounting N/R w/out recourse (true sale)
Holder assumes no further liability
True sale
J/E to record discount N/R w/out recourse
Dr. Cash
Dr. Loss
Cr. N/R
What is the effect of expected exchanges on net sales and inventory?
No effect
How are deferred tax liabilities classified?
Based on the classification of the related asset or liability
Why would cash in a bond sinking fund not be classified as cash and cash equivalents?
Because it is restricted
Why would commercial paper that matures in 2 months be classified as cash and cash equivalents?
Because it is a liquid investment near maturity (within 3 months of purchase date) that risk of changes in value b/c interest rate changes is insignificant
