Current Assets

Current assets include inventory, cash and accounts receivables. It is in this category that accountants are most amenable to the use of market value, especially in valuing marketable securities.

• Accounts receivable represent money owed by entities to the firm on the sale of products on credit. The accounting convention is for accounts receivable to be recorded as the amount owed to the firm, based upon the billing at the time of the credit sale. The only major valuation and accounting issue is when the firm has to recognize accounts receivable that are not collectible. Firms can set aside a portion of their income to cover expected bad debts from credit sales, and accounts receivable will be reduced by this reserve. Alternatively, the bad debts can be recognized as they occur and the firm can reduce the accounts receivable accordingly. There is the danger, however, that absent a decisive declaration of a bad debt, firms may continue to show as accounts receivable amounts that they know are unlikely to be ever collected.

• Cash is one of the few assets for which accountants and financial analysts should agree on value. The value of a cash balance should not be open to estimation error. Having said this, we should note that fewer and fewer companies actually hold cash in the conventional sense (as currency or as demand deposits in banks). Firms often invest the cash in interest-bearing accounts or in treasuries, so as to earn a return on their investments. In either case, market value can deviate from book value, especially if the investments are long term. While there is no real default risk in either of these investments, interest rate movements can affect their value.

• Three basis approaches to valuing inventory are allowed by GAAP: FIFO, LIFO and Weighted Average.

(a) First-in, First-out (FIFO): Under FIFO, the cost of goods sold is based upon the cost of material bought earliest in the period, while the cost of inventory is based upon the cost of material bought latest in the year. This results in inventory being valued close to the current replacement cost.

(b) Last-in, First-out (LIFO): Under LIFO, the cost of goods sold is based upon the cost of material bought latest in the period, while the cost of inventory is based upon the cost of material bought earliest in the year. This results in finished goods being valued close to the current production cost.

(c) Weighted Average: Under the weighted average approach, both inventory and the cost of goods sold are based upon the average cost of all materials bought during the period. When inventory turns over rapidly, this approach will more closely resemble FIFO than LIFO.

Firms often adopt the LIFO approach for its tax benefits during periods of high inflation. The cost of goods sold is then higher because it is based upon prices paid towards to the end of the accounting period. This, in turn, will reduce the reported taxable income and net income, while increasing cash flows. Given the income and cash flow effects of inventory valuation methods, it is often difficult to compare the inventory values of firms that use different methods. There is, however, one way of adjusting for these differences. Firms that choose the LIFO approach to value inventories have to specify in a footnote the difference in inventory valuation between FIFO and LIFO, and this difference is termed the LIFO reserve. It can be used to adjust the beginning and ending inventories, and consequently the cost of goods sold, and to restate income based upon FIFO valuation.

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