Prepaids and Deferrals in Working Capital - Coursework Example

INVENTORY, PREPAIDS AND DEFERRALS IN WORKING CAPITAL of Contents Introduction 3 Inventory and Working Capital 3 Inventory can be considered as an asset as well as liability 4 Increase in working capital might not increase liquidity 4 Inflated working capital due to inclusion of obsolete inventory 4 Inventories can be overvalued 5 Inventories might not be as liquid as estimated 5 Prepaid and Deferred Expenses and Working Capital 5 Prepaid and Deferred Expenses cannot be easily liquidated 6 Prepaid and Deferred Expenses might be unrelated to business activity 6 Changes in Prepaid and Deferred Expenses does not reflect changes in company’s liquidity 7 Prepaid and Deferred Expenses are potential expenses and do not reflect actual payments 7 Prepaid and Deferred Expenses are potential assets that cannot be used to pay liabilities 7 Deferrals and Working Capital 7 Deferred Revenue unnecessarily reduces working cash position 8 Deferred Revenue does not need to be repaid 8 Deferred Revenue changes might falsify working capital position 8 Deferred Revenue does not account for loss due to actual sales 9 Deferred Revenue cannot be liquidated easily 9 Conclusion 9 References 11 Introduction Adjustments in working capital were designed with a view to make sure that the business has enough cash to meet its ordinary course of operations without needing to add more capital from equity or debt sources. The way, in which working capital changes have been incorporated in changing the competitive environment of today, additional pressure is being built on working capital accounting. Inventory and Working Capital A company’s inventory accounting is disclosed in the notes to accounts. The main objective of reporting for inventory as per the IASB is to determine the exact amount of cost that is to be recognized as an asset unless the real revenues are recognized. Inventory forms a major component of the working capital accounting process and hence is considered to be an asset for the company that will generate additional cash flow when cash flow is realized (Mulford & Comiskey, 2005). Working capital and inventory have somewhat of a symbiotic relationship where inventory is accounted within the current assets side of the working capital measurement formula (Schroeder, Clark & Cathay, 2011). Working capital is measured as current assets minus current liabilities. Organizations that have large amounts of sales are often left with huge inventory positions. This brings in a huge change in the working capital position of the company. Hence we understand how inventory can be used to manipulate liquidity position while calculating working capital (Narayanan & Nanda, 2004). It is argued that inventory should not be included while calculating for working capital to determine the liquidity positions of the company. A far better representation of company’s liquidity is the quick ratio where inventories are removed. The rationale behind such argument is as below. Inventory can be considered as an asset as well as liability Inventory is generally considered on the asset side of the balance sheet under the current asset subhead. The logic behind being that inventories are finished goods or work in progress that shall get sold and liquidated soon and shall there by generate revenue causing a positive cash flow to the business. However, certain corporations also consider inventory as current liability. Their argument is that inventories can be used in exchange of bills payable and such other short term loans which becomes a liability for the business unless it is paid off. Also as per the ASB opinion 9, current liabilities are classified as obligations theta are expected to be liquidated within a period of one year or the normal operating cycle (US GAAP, n.d.). Hence inventory inclusion might also create misleading figures and manipulation of working capital figures by corporations. Increase in working capital might not increase liquidity For the purpose of calculating working capital, any increase in the working capital does not reflect a change in the availability of free cash to the business. This means the changes in working capital might also arise out of an increase in inventory which does not provide for an immediate cash or liquidity. This can give a wrong picture of operating position of the firm while calculating for working capital. Inflated working capital due to inclusion of obsolete inventory Many companies record their inventory figures over a long time period. This implies that if the inventory is accounted on the asset side, the company might have an inflated working capital figure when inventories remain for long periods of time. This portrays a strong picture of company’s working capital and thereby powerful operating cycle liquidity that leads to manipulation of accounts and representation. Inventories can be overvalued Inventories included in the financial statement are reflected in terms of cost of finished goods that are yet to be sold in the market. As per ARB 43, inventories are valued at cost. It is quite possible that the cost of finished goods might be higher that the value it is realized for at the time of sale. In the event that cost of goods is much higher that \n sales value, working capital figure shows an inflated assessment. Net realizable value is based on market forces. This can be quite misleading in interpreting the liquidity position of the company. Inventories might not be as liquid as estimated In the event that companies want to raise their working capital; requirements and are in need of additional cash, a mere rise in inventories or accounts receivable might not result in increase in liquidity. This is because the company might not be able to sell off its finished goods as quickly as its need for cash. Therefore, working capital increments can be quite misleading when it comes to requirement of liquidity by a firm. Prepaid and Deferred Expenses and Working Capital Prepaid and Deferred Expenses are advance payments for expenses like the annual insurance and such other expenses that the company is yet to incur. Such expenses are recorded in the asset side of the balance sheet under current assets. Prepaid and Deferred Expenses that account for over one year are put under long term assets and do not enter the calculation for working capital (Wisdom & Hasselback, 2008). `In the event of requirement of working capital such assets are not liquid. There is no procedure for reversal of Prepaid and Deferred Expenses and neither can short term loans be borrowed against such expenses. Hence Prepaid and Deferred Expenses should not be included in determination of a firm’s liquidity. Prepaid and Deferred Expenses revenues reflect the potential liability of revenues and not the actual liability and are represented as current liabilities and incorporated within the working capital calculations. Prepaid and Deferred Expenses cannot be easily liquidated The problem in determining company liquidity position in times of additional cash requirements arises when the company needs additional cash to manage its operational requirements. In such an event it is difficult to liquidate Prepaid and Deferred Expenses. These assets are non tangible and do not provide much support even in case of borrowing for short terms. Hence Prepaid and Deferred Expenses are illiquid assets that should be eliminated from the calculation of working capital and hence company’s operating liquidity position Prepaid and Deferred Expenses might be unrelated to business activity It is quite possible that Prepaid and Deferred Expenses might be incurred as a result of some obligation that is not directly related to the business activity. In such a scenario, reflection of Prepaid and Deferred Expenses as current assets inflates company’s liquidity position unnecessarily. Payment for insurance that is not related to the production activity like car insurance might block cash unnecessarily for the short term and hamper company’s liquidity position. Changes in Prepaid and Deferred Expenses does not reflect changes in company’s liquidity A rise in Prepaid and Deferred Expenses might raise company’s working capital but in real terms, it only increases expenses that have been made earlier and no change happens in the position of liquid cash. A fall in Prepaid and Deferred Expenses might reflect as a fall in company’s working capital but it makes no real change in cash position or liquidity of the company. Prepaid and Deferred Expenses are potential expenses and do not reflect actual payments Potential expenses might or might not be incurred in future. Advance payment for such expenses has the possibility of going waste if not required in future. For example, advance payment of payroll might go waste if the employee discontinues his services. Hence, such reflection of current asset is not a true representation of the working capital figure. Prepaid and Deferred Expenses are potential assets that cannot be used to pay liabilities Prepaid and Deferred Expenses are relatively very small compared to the rest of the balance sheet. These cannot be used up to write off any expenses or pay off any liabilities and hence should be written off from the working calculation. They are grouped within current assets as per the accounting convention but shall not generate any liquidity to pay off current liabilities. Working capital is better represented when Prepaid and Deferred Expenses do not exist. Deferrals and Working Capital The FASB matching principal of accounting states that revenue should be recognized only when it is realized in physical terms (FASB, 2012). An accounting problem arises when the client pays in advance. Such payments are not to be recognized unless sales are physically made because such recording might inflate the net worth for the company and the transaction remains incomplete. When such prepayments cause a rise in assets in terms of cash, deferred revenues are recorded on the liabilities side of the balance sheet under current liabilities. Deferred Revenue unnecessarily reduces working cash position Deferred revenue is increase in cash position due to prepayment by a client. It does not increase an additional liability and thus cannot be termed as a traditional liability that reduces company’s cash position. It is because o the accounting treatment that such liability recording needs to be done to balance the two sides of the accounting statements. Such non obligatory liabilities reduce company’s liquidity unnecessarily and give a wrong image of company’s working capital position. Deferred Revenue does not need to be repaid Deferred revenues are cash positions that are received in advance for no real sales made at that point of time. These liabilities do not need additional cash and or do not raise liability of payments. Hence the obligation to repay the liability unnecessarily increases and put pressure on company cash position with but not in real terms. This degrades company’s liquidity and calls for a need to add additional liquidity. Deferred Revenue changes might falsify working capital position Deferred Revenue might be increased due to additional prepayments by the clients. As per accounting norms, the current liabilities position shall also increase to match the influx of cash. This dual effect on the working capital is an unnecessary calculation that needs to be removed to reflect the actual cash and liability position. The matching principal followed here does not give a correct view of company’s working capital position. Deferred Revenue does not account for loss due to actual sales Deferred revenue might be recorded at sales price prevailing at the point at which the prepayment was made. However, actual sales made might be different that for which money was received in advance. The difference in prices of goods between these time periods do not get recorded in the working capital calculation and thus bring about a mismatch in the cash and liability position. Deferred Revenue cannot be liquidated easily FASB technical bulletin states that under ARB 43, Chapter 3A, current liability should be classified and should include due on demand and will be due on demand within a year or within the operating cycle, whichever is longer from the last date when the balance sheet was prepared despite the fact that liquidation might not occur within that period (FASB, 2008). Deferred revenue is liquidated only in the event of actual sales being made. In the case where sales get delayed for various reasons, deferred revenue continue to weigh on the current liabilities putting and extra pressure on company cash without any subsequent payments required. Conclusion Despite the fact that there are many criticisms to the relevance of the classification of current and non-current assets and liabilities, the IASB takes the same stand and requires that (IAS 1: 51) for an entity, current and noncurrent assets and current and noncurrent liabilities should be presented as separate classifications (Ernst & Young, 2007). It does not allow for any exception to be made in the case of liquidity, which could be an upward or a downward movement even if such movement shall be more reliable and relevant. There is also no choice in realization of all amounts that are due to be received or paid and all of it should be done within a period of 12 months and remain bound to be disclosed. References Ernst & Young. (2007) International GAAP 2008: Generally Accepted Accounting Practice under International Financial Reporting Standards. New Jersey: John Wiley and Sons. FASB. (2008) Statement of Financial Accounting Standards No. 78. Retrieved from http://www.fasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175820904316&blobheader=application/pdf&blobheadername2=Content-Length&blobheadername1=Content-Disposition&blobheadervalue2=88522&blobheadervalue1=filename=aop_FAS78.pdf&blobcol=urldata&blobtable=MungoBlobs FASB. (2012) Proposed Accounting Standards Update (Revised). Retrieved from http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175823564392&blobheader=application%2Fpdf Mulford, C. W. & Comiskey, E. E.. (2005). Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance. New Jersey: John Wiley and Sons. Narayanan, M. P. & Nanda, V. K. (2004) Finance for Strategic Decision-Making: What Non-Financial Managers Need to Know. New Jersey: John Wiley and Sons. Schroeder, R. G., Clark, M. W. & Cathay, J. M. (2011) Financial Accounting Theory and Analysis: Text and Cases. New Jersey: John Wiley and Sons US GAAP. (n.d.) Accounting Research Bulletin (ARB) No. 43. Retrieved from http://cpaclass.com/gaap/arb/gaap-arb-43.htm Wisdom, J. C. & Hasselback, J. R. (2008) U.S. Master Accounting Guide, 2008. Chicago: CCH. Read More