managerial accoutning discussion 2

“Liquidity Ratios” Please respond to the following:

From the first e-Activity, evaluate the impact of not considering the current portion of long-term liabilities in the current ratio and working capital, and how this may impact day- to-day business decisions.

Determine the implications of a significant positive change in the ratio. Provide a rationale with your response.

 

Comprehensive Income” Please respond to the following:

•From the second e-Activity, elaborate on the potential consequences of eliminating the option to present other comprehensive income within the statement of changes in equity on financial statement users and companies.

•Evaluate the effect of the increased prominence of other comprehensive income on financial statement users and companies.

“Liquidity Ratios” Please respond to the following:

· From the first e-Activity, evaluate the impact of not considering the current portion of long-term liabilities in the current ratio and working capital, and how this may impact day- to-day business decisions.

· Determine the implications of a significant positive change in the ratio. Provide a rationale with your response.

Comprehensive Income” Please respond to the following:

•From the second e-Activity, elaborate on the potential consequences of eliminating the option to present other comprehensive income within the statement of changes in equity on financial statement users and companies.

•Evaluate the effect of the increased prominence of other comprehensive income on financial statement users and companies.

Article #1

The missing piece in liquidity calculations

Why calculating the “current portion of

fixed asset

s” would provide a more accurate picture of financial health

By Stephen Bartoletti

April 2012

A fundamental flaw in U.S. GAAP and IFRS financial reporting standards distorts the calculation of working capital and the current ratio, resulting in a significant understatement in most companies’ liquidity. This outcome is detrimental not only to the companies but also to the economy overall, because it reduces the amount of credit available to businesses.

A particularly negative consequence occurs when the flaw results in the reporting of a negative level of working capital—one of the stress alarms that auditors use to determine if they should report that a company is in danger of bankruptcy. Consider this common scenario: George has $5,000 to

start a business

and $200 in his pocket. He wins a lottery for a license to own and operate a taxi. He puts $5,000 down on a $25,000 car and borrows the difference, $20,000, on a five-year loan.

His balance sheet is simple:

· One current asset = $200 cash.

· One fixed asset = the car at full value of $25,000.

· One current liability = the current portion of long-term debt (CPLTD) of $4,000 (one-fifth of the $20,000 loan balance).

· One long-term liability = $16,000 (four-fifths of the loan balance).

· Equity = $5,200.

What is George’s “working capital”? According to conventional thinking, it would be defined as current assets ($200 cash) minus current liabilities ($4,000 CPLTD) or a negative $3,800. Right from the start of his business, George has a negative level of working capital. Moreover, with no inventory and no accounts receivable (since even

credit cards

clear in a day), George will have a negative working capital for the next five years.

The common view of this situation based on this method of calculation is that George’s business is illiquid and he won’t be able to repay his loan. But that’s not correct.

Conventional accounting reports CPLTD among current liabilities because, logically, it is a liability due in the current period. However, that approach implies that CPLTD will be repaid from the conversion of current assets into cash.

But, in reality, George will repay his loan with the revenue that he takes in using the taxi, which is a fixed asset.

Here is the problem: The standard balance sheet fails to match the CPLTD with the fixed asset that repays it—the taxi. To truly “balance” our balance sheet in terms of what is current and what is long term, a new concept is needed—the current portion of fixed assets (CPFA). The CPFA is the portion of the fixed asset—the taxi—that will be used up in the current period to generate revenue. A simple accounting definition, and calculation of this concept, would be: The portion of fixed assets that will be depreciated in the current (next) period.

In this example, if we assume the taxi has a five-year useful life, George will “use up” one-fifth of the taxi each year to generate cash revenue (a different expected life only changes the calculations, not the concepts). The “current portion” of the taxi, the CPFA, thus is $5,000 (or $25,000 divided by five years).

Notice that, when CPFA is added to the balance sheet, as seen in Exhibit 1, each liability is now properly matched with the asset that it finances and that will repay it.

As this exhibit shows, George is not illiquid. He has $200 (for an initial tank of gas and some food) and zero “current liabilities.” He will make his

first loan

payment from the cash revenue he collects this month, which is generated by using the taxi.

George is not the only victim of the conventional approach to calculating working capital. Companies that have a large quantity of fixed assets and long-term debt—and therefore a large CPLTD—often appear to be tight on working capital, sometimes even reporting a negative working capital. Take CPLTD out of the equation, and their true liquidity is much rosier.

DSCR VALIDATED
“Best practices” in commercial lending use the debt service coverage ratio (DSCR) to measure repayment of long-term loans. DSCR is calculated as: (Net profit + depreciation – distributions) ÷ CPLTD.

The DSCR is a powerful ratio. It correctly captures the concept that the use of the fixed asset generates revenue that is used to repay the CPLTD. The portion of the taxi that is “used up” (depreciated) in generating revenue is effectively converted into cash flow.

However, DSCR measures last year’s depreciation expense against next year’s loan repayment. A superior DSCR would pit next year’s depreciation expense—calculated as CPFA—against next year’s loan repayment.

In George’s case, next year’s depreciation expense (CPFA) of $5,000 will be adequate to repay the CPLTD of $4,000. This equates to a DSCR of 1.25 ($5,000 ÷ $4,000) if we assume zero net profit and no distributions. At break-even (zero profit), the company generates exactly enough revenue to cover all expenses, including George’s cash expenses (fuel, repairs, interest expense and a salary) and depreciation expense.

To be clear, it is neither the depreciation expense nor the CPFA that repays the CPLTD. Revenue repays CPLTD. The depreciation expense only measures the portion of revenue that is available to repay CPLTD after all cash expenses are paid.

There is, of course, a business risk that revenue could fall short of break-even. If the company suffers a net loss, there may not be enough revenue to cover both cash expenses and CPLTD. Of course, any company that consistently loses money will have a hard time repaying its long-term debt. A policy that requires some minimum DSCR would preclude long-term loans to companies that cannot at least break even.

CURRENT RATIO CONSIDERED
If the premise is accepted that CPLTD is repaid from CPFA and not from current assets, it must follow that the current ratio is flawed by including CPLTD as a current liability that must be paid from current assets. The distortion arises from the failure to match CPLTD with its source of repayment, CPFA.

Two approaches could fix the distorted liquidity picture:

Solution 1: Focusing on the trading cycle.
This approach would take CPLTD out of current liabilities, or at least adjust the calculation of working capital and current ratio accordingly. That would require inventing some new terms:

Replace working capital with: Trading cycle capital = current assets – (current liabilities – CPLTD).

Replace the current ratio formula with: Trading cycle ratio = current assets ÷ (current liabilities – CPLTD).

Solution 2: Developing a new “current ratio.”
The alternate solution is to leave CPLTD with current liabilities, but calculate CPFA and report it with current assets.

Replace working capital with: Current capital = current assets (including CPFA) – current liabilities (including CPLTD).

Replace current ratio with: Current period ratio = current assets (including CPFA) ÷ current liabilities (including CPLTD).

Academics may debate whether the most appropriate treatment is (Solution 1) to move CPLTD from “current” back to long-term to match it with the fixed assets it finances; or (Solution 2) to take the portion of the fixed asset that is “current” and move it up with current assets. In either case, CPFA and CPLTD must match up.

Either approach would be an improvement over the traditional measures of liquidity, but since the approaches provide different information, taken together they provide a clearer understanding of liquidity than was previously possible. A look at how cash flows in cycles reveals the unique contributions of the approaches.

The “short-term cycle” only includes current assets and current liabilities that financed them and are repaid by them. Sometimes called “trading accounts,” these exclude CPLTD. By excluding CPFA and CPLTD from the formulas, Solution 1 provides a valuable analysis of the short-term cycle: Are current assets (traditionally defined to exclude CPFA) adequate to repay the short-term liabilities that financed them (excluding CPLTD)?

The “long-term cycle” matches fixed assets with the long-term liabilities that financed them. However, CPLTD and CPFA complicate the understanding of short-term and long-term cash flow cycles because they contain elements of both cycles, as their titles indicate: “The current portion of long-term debt” and “the current portion of fixed assets.” They are, in fact, the “the current portion of the long-term cycle,” which places them at the intersection of both time periods.

Notice that CPLTD appears in both the measure for the repayment of short-term debt—the current ratio—and the measure for the repayment of long-term debt—the DSCR. That is because the traditional current ratio encompasses both cycles, including both short-term liabilities and the current portion of long-term liabilities. The proposed “current period ratio” (Solution 2) shares this objective; however, it adds the missing piece—the CPFA—to the “current” assets, thereby pitting all assets that are converted into cash in the current period against all liabilities due in the current period.

The current period ratio (Solution 2) is therefore the closer substitute for the old current ratio. The trading cycle ratio (Solution 1)—which is a narrower measure of liquidity than the current-period ratio—can be thought of as a substitute for the old acid-test ratio (or quick ratio), which also was intended to give a narrower measure of liquidity by excluding less-liquid accounts such as inventory. However, the old acid-test ratio suffers from the same flaw as the old current ratio—it erroneously suggests that CPLTD, included as a current liability, is repaid by the current (acid) assets.

The decision going forward is not which of the two new ratios is more useful. Indeed, the greatest insight comes when the two ratios yield opposite indications. For example, a negative trading capital and a positive current-period capital would indicate that the short-term assets do not cover short-term liabilities, but the company is able to keep current because the long-term cycle is generating cash flow (CPFA) adequate to repay both the CPLTD and any shortfall in the short-term cycle. This situation may not be sustainable and may suggest that the mix of short-term and long-term debt is not optimal. Only by using the measures together is a more comprehensive understanding of liquidity possible.

SETTING THE STAGE FOR CHANGE
Discussion of these alternate approaches to assessing working capital is somewhat academic at this time because CPFA is not presently calculated and reported.

CPFA is a new concept, but it is easy to understand: It is the portion of the fixed assets that will be “used up” in the coming year to generate revenue. And it is easy to calculate: It is the scheduled depreciation for the coming year, just as CPLTD is the scheduled principal payments for the coming year.

CPFA should be part of standard reporting. Without CPFA, the traditional measures of liquidity routinely understate liquidity. AT&T, which reported a negative working capital of $14 billion at year-end 2010 ($20 billion current assets less $34 billion current liabilities), “appears” to be illiquid, but only because CPLTD is not matched with CPFA. The “appearance” of illiquidity may not hurt AT&T, but lenders generally shy away from small and medium-size companies that “appear” to be illiquid. The suppression of credit resulting from incorrect indicators hurts not only certain companies but also the economy as a whole.

CPAs and auditors have an advantage over lenders and security analysts because they have access to the necessary raw data—the schedule of next year’s depreciation—needed to calculate CPFA and a correct current-period ratio. They should do so, because reporting a company to be illiquid or worse, near bankruptcy, based on faulty ratios is as detrimental as failing to identity a truly illiquid firm.

 
EXECUTIVE SUMMARY
 

  A current flaw in U.S. GAAP/IFRS financial reporting standards distorts the calculation of working capital and the current ratio, understating the liquidity of most companies.

  Conventional financial reporting places the current portion of long-term debt (CPLTD) among current liabilities because it is a liability due in the current period. That approach, however, incorrectly implies that CPLTD will be repaid from the conversion of current assets into cash.

  The standard balance sheet fails to match the CPLTD with the fixed asset that repays it. To truly “balance” a balance sheet in terms of what is current and what is long term, a new concept is needed—the current portion of fixed assets (CPFA). The CPFA is the portion of the fixed asset that will be used up in the current period to generate revenue. This year’s CPFA is next year’s depreciation expense.

  The debt service coverage ratio, used in commercial lending, is an effective tool for measuring repayment of long-term loans. It correctly captures the concept that the use of the fixed asset generates revenue that is used to repay the CPLTD.

  Two possible approaches could fix the current distorted liquidity picture: focusing on the trading cycle by taking CPLTD out of current liabilities; or developing a new “current ratio” that leaves CPLTD with current liabilities but calculates CPFA and reports it with current assets. The latter approach would require a change in financial reporting standards.

Stephen Bartoletti
(
bartoletti@sme-lending.com
) is an independent, senior banking adviser.

To comment on this article or to suggest an idea for another article, contact Kim Nilsen, executive editor, at
knilsen@aicpa.org
or 919-402-4048.

 
AICPA RESOURCES

JofA article
“Asset-Based Financing Basics,” Aug. 2011, page 40

Publications
·
Optimizing Company Cash: A Guide for Financial Professionals
(#029882)
·
Guide to Financial Statement Analysis: Basis for Management Advice
(#091022)
·
Cost of Capital: Applications and Examples
, 4th edition (#WI476055)

CPE self-study
· Financial Statement Analysis: Basis for Management Advice (#731254)
· GAAP Review Series Part 1 (#732717)
· IFRS: Financial Statements, Interim Reporting, and Cash Flows (IAS 1, IAS 34, and IFRS 7) (#159748)
· Statement of Cash Flows: Preparation, Presentation and Use (#731849)

Article #2

FASB Defers Part of Comprehensive Income Standards Update

 
December 23, 2011
FASB on Friday released an update that defers a portion of new accounting requirements for comprehensive income issued earlier this year.
The update defers the requirement to present items that are reclassified from accumulated other comprehensive income to net income separately with their respective components of net income and other comprehensive income.
FASB issued Accounting Standards Update (ASU) no. 2011-12, Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.
The original standard, ASU no. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, was intended to make other comprehensive income more prominent in financial statements and to facilitate convergence of U.S. GAAP and IFRS. The standard, issued in June, supersedes some of the guidance in Accounting Standards Codification Topic 220, Comprehensive Income.
The standard gives entities the option of reporting items of other comprehensive income in either one or two consecutive financial statements. In a single statement, the entity must present the components of net income and total net income; the components of other comprehensive income and total other comprehensive income; and a total for comprehensive income.
Should the entity choose a two-statement approach, the components of net income and total net income must be presented in the first statement. A second statement must immediately follow presenting the components of other comprehensive income, a total for other comprehensive income, and a total for comprehensive income.
FASB said stakeholders raised concerns about the cost and complexity of reclassifying items out of accumulated other comprehensive income in the new standard. FASB decided to reconsider whether it’s necessary to require companies to present reclassification adjustments by components in both interim and annual financial statements for both:
· The statement where net income is presented.
· The statement where other comprehensive income is presented.
The deferral supersedes only the paragraphs pertaining to how and where reclassification adjustments are presented. While FASB reconsiders that guidance, entities will continue to report reclassifications out of accumulated comprehensive income consistent with the presentation requirements in effect before ASU 2011-05, according to a FASB news release.
For public entities, the amendments take effect for fiscal years and interim periods within those years beginning after Dec. 15, 2011. The amendments take effect for nonpublic companies and nonprofits for fiscal years ending after Dec. 15, 2012, and interim and annual periods afterward.
Article #3

FASB, IASB Align Presentation of Other Comprehensive Income

 
June 17, 2011
FASB on Thursday issued an Accounting Standards Update (ASU) that the board said is intended to increase the prominence of other comprehensive income in financial statements and to facilitate convergence of U.S. GAAP and IFRS. Simultaneously, the International Accounting Standards Board (IASB) issued amendments to IAS 1, Presentation of Financial Statements.
FASB’s summary of the ASU noted that, while it reached agreement with the IASB on how items of comprehensive income should be reported, differences between U.S. GAAP and IFRS remain.
For both U.S. GAAP and IFRS, the amendments require that all nonowner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The option in current U.S. GAAP that permits the presentation of other comprehensive income in the statement of changes in stockholders’ equity has been eliminated.

FASB ASU no. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, will supersede some of the guidance in Accounting Standards Codification Topic 220, Comprehensive Income.
The main provisions of ASU no. 2011-05 provide that an entity that reports items of other comprehensive income has the option to present comprehensive income in either one or two consecutive financial statements:
· A single statement must present the components of net income and total net income, the components of other comprehensive income and total other comprehensive income, and a total for comprehensive income. 
· In a two-statement approach, an entity must present the components of net income and total net income in the first statement. That statement must be immediately followed by a financial statement that presents the components of other comprehensive income, a total for other comprehensive income, and a total for comprehensive income.
The amendments do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income, according to FASB’s summary of the ASU. But regardless of whether an entity chooses to present comprehensive income in a single continuous statement or in two separate but consecutive statements, the entity is required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented.
The amendments do not change the option for an entity to present components of other comprehensive income either net of related tax effects or before related tax effects, with one amount shown for the aggregate income tax expense or benefit related to the total of other comprehensive income items, according to FASB’s summary. In both cases, the tax effect for each component must be disclosed in the notes to the financial statements or presented in the statement in which other comprehensive income is presented. The amendments do not affect how earnings per share is calculated or presented.
FASB’s summary also said that differences in reporting comprehensive income between U.S. GAAP and IFRS remain. In particular, there are some differences between the types of items reported in other comprehensive income and the requirements for reclassifying those items into net income. FASB said that removing certain presentation options will make it easier to compare statements of comprehensive income prepared using the different standards.
The amendments in the ASU should be applied retrospectively. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after Dec. 15, 2011. For nonpublic entities, the amendments are effective for fiscal years ending after Dec. 15, 2012, and interim and annual periods thereafter. Early adoption is permitted, because compliance with the amendments is already permitted.
FASB prepared a “FASB In Focus” (a high-level summary of the proposal) and a podcast discussing the ASU.
The IASB’s amendments to IAS 1 are effective for financial years beginning on or after July 1, 2012. An IASB Project Summary and Feedback Statement explaining how the IASB responded to views received during its consultations as well as a podcast introducing the amendments are available on the project page.
The IASB said requiring other comprehensive income to be presented as part of, or in close proximity to, the profit or loss (income) statement will make it easier for users of financial statements to assess the effect of other comprehensive income items on the overall performance of an entity and improve comparability between IFRS and U.S. GAAP.
Complete coverage of convergence issues is available at the JofA’s “IFRS Resources” page.