Financial Reporting Chapter 4: Liquidity

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Questions and Answers

What is the primary characteristic of unrestricted cash?

Reported as a noncurrent asset

Restricted by regulations

Not available for all transactions

Can be used to pay creditors (correct)

What does restricted cash imply?

It is not reported on financial statements

It can only be used to pay long-term liabilities

It can be freely used for any transaction

It may be reported as a current asset but with disclosed restrictions (correct)

What impact does a compensating balance have on loan proceeds?

It reduces the loan amount available (correct)

It decreases the effective interest rate

It is not considered in financial statements

It can be reported as current liabilities

How is cash typically titled on the balance sheet?

Cash and equivalents Signup and view all the answers

What analysis issues might arise from cash reporting?

Determining fair valuation and liquidity Signup and view all the answers

When cash is used as a compensating balance, what must be noted?

It increases the effective interest rate Signup and view all the answers

Which of the following is NOT a title for the cash account on the balance sheet?

Cash and investments Signup and view all the answers

Where are compensating balances reported in financial statements?

Separately stated in current assets or as noncurrent assets under other categories Signup and view all the answers

What is a key characteristic of the perpetual inventory system?

Records are updated at the time of sale or purchase Signup and view all the answers

Which of the following best describes FIFO (first-in, first-out) inventory management?

It does not take current costs into account Signup and view all the answers

What is a disadvantage of using FIFO during inflationary periods?

It inflates profits Signup and view all the answers

Which method is typically impractical for tracking specific costs?

Specific identification method Signup and view all the answers

In a periodic inventory system, how is ending inventory determined?

Through frequent physical counts and cost assumptions Signup and view all the answers

Which of the following is a potential issue with low inventory turnover using FIFO?

Overvaluation of inventory based on replacement cost Signup and view all the answers

Which of the following is NOT a method of inventory cost flow assumptions?

Specific identification Signup and view all the answers

What is the primary advantage of the periodic inventory system?

It reduces administrative work Signup and view all the answers

What is the effect of high inventory on days' sales in inventory?

Days' sales in inventory are overstated and liquidity is understated Signup and view all the answers

Which inventory turnover ratio indicates a more dynamic selling activity?

A high ratio indicates high turnover of inventory Signup and view all the answers

What could be a consequence of having a low inventory?

Unrealistic days' sales in inventory leading to potential lost sales Signup and view all the answers

What is a recommended practice for determining average inventory for external analysis?

Use quarterly data to reflect trends Signup and view all the answers

What is the formula for calculating Inventory Turnover in Days?

Average Inventory / Cost of Goods Sold * 365 Signup and view all the answers

Why should caution be exercised when comparing natural year companies with calendar year companies?

Seasonal fluctuations can distort comparisons Signup and view all the answers

What impact does using LIFO have on inventory valuation and turnover?

It generates lower inventory values and higher turnover Signup and view all the answers

What does the Operating Cycle measure?

The total time between acquisition of goods and cash realization Signup and view all the answers

What is a potential issue when comparing inventory turnover across different industries?

Inter-industry comparisons may not be reasonable due to differing practices Signup and view all the answers

Which factor could lead to an understatement of turnover measures?

Use of a natural business year Signup and view all the answers

How are prepayments categorized in relation to short-term debt-paying ability?

They have no effect on liquidity Signup and view all the answers

What is the formula for calculating inventory turnover?

Inventory Turnover = Cost of Goods Sold / Average Inventory Signup and view all the answers

Which of the following statements about Inventory Turnover per Year is correct?

It is calculated by dividing 365 by Inventory Turnover in Days Signup and view all the answers

What is the key characteristic of prepayments?

They are not expected to influence operational cash flow Signup and view all the answers

Which of the following is NOT a component of the Operating Cycle?

Cash Management Cycle Signup and view all the answers

Which of the following is the correct approach for valuation of prepayments?

Cost paid for the unexpired benefits Signup and view all the answers

What is the average unit cost calculated from the provided inventory data?

$7.95 Signup and view all the answers

What is the total cost of goods sold based on the ending inventory calculation?

$10,340 Signup and view all the answers

If 800 units are in ending inventory, what is their total value using the average unit cost?

$6,360 Signup and view all the answers

What effect does using the LIFO method have on short-term debt-paying ability?

Understates it Signup and view all the answers

What is the total cost of the purchases made on 01-Mar?

$8,400 Signup and view all the answers

What is the result of subtracting the ending inventory value from the total cost?

Cost of Goods Sold Signup and view all the answers

What is the cost per unit for the January 1 beginning inventory?

$6.00 Signup and view all the answers

What does the LIFO cost flow assumption focus on?

Matching the most recent costs with sales revenue Signup and view all the answers

What effect does using the Average Cost method have during inflation?

Inventory valuation will be lower than LIFO. Signup and view all the answers

What is the impact of LIFO on ending inventory valuation?

Ending inventory contains older costs. Signup and view all the answers

How is the Cost of Goods Sold calculated under LIFO?

By calculating costs from the latest purchases sold first. Signup and view all the answers

Which of the following statements is true regarding FIFO?

FIFO values ending inventory using the oldest costs. Signup and view all the answers

What would happen to the inventory valuation using FIFO if prices are rising?

It would increase significantly. Signup and view all the answers

In a cost flow assumption example, if 800 units are sold under LIFO, what would be the cost of goods sold if the latest acquisitions were used first?

$11,300. Signup and view all the answers

Which cost flow assumption leads to the largest cost of goods sold during inflation?

LIFO. Signup and view all the answers

If a company uses the Average Cost method, how would it measure cost of goods sold during deflation?

It would reflect costs that are lower than both FIFO and LIFO. Signup and view all the answers

What is a primary characteristic of the Average Cost method?

It provides the midpoint between FIFO and LIFO calculations. Signup and view all the answers

Study Notes

Financial Reporting & Analysis

This is a textbook about financial reporting and analysis, using financial accounting information.
The author is Charles H. Gibson.

This chapter focuses on short-term assets and their implications for a company's ability to pay its debts.

Current Assets

Current assets are resources a business expects to convert to cash or use within one year or its operating cycle (whichever is longer).
Examples include cash, marketable securities, receivables (money owed to the company), inventories, and prepayments.

Operating Cycle

The operating cycle is the time period between acquiring goods and the final cash realization from sales.
The cycle varies depending on whether the business models are wholesale, retail, or manufacturing.
Detailed cycles for each model are described.

Current Assets: Cash

Unrestricted cash is available for general use in paying creditors or making deposits.
Restricted cash is limited in its use. Companies may need to disclose restrictions.
Cash and cash equivalents, or cash and certificates of deposit, are listed in accounting statements.
The analysis includes determining fair valuation, and asset liquidity.
Compensating balances are also important to understand.

Current Assets: Marketable Securities

To be considered a marketable security, the investment must be readily convertible to cash.
This conversion must occur within one year or the operating cycle (whichever is longer).
Examples are treasury bills, short-term notes, corporate bonds, and stock.
These are recorded at fair value.

Current Assets: Receivables

Receivables represent claims to future cash inflows from credit sales.
This includes accounts receivables and notes receivables, often referred to as trade receivables.
Valuation problems are a concern, as costs are incurred up to the time the receivables are collected.
Collections may not always occur (write-off), and this impacts the relevant financial statement accounts.
Causes of impairment (diminished value) include uncollectibility, discounts allowed, allowances granted, and sales returns.
Companies accrue an allowance for doubtful accounts for valuation.

Current Assets: Receivables—Continued

Waiting periods related to interest rates are ignored.
Noninterest-bearing or unreasonable-rate notes are recorded at present value.
The methods to calculate impairment include accrual (allowance method).
Different types of receivables—trade and installment—differ in payment timing.
Customer concentration and liquidity ratios (number of days' sales in receivables and accounts receivable turnover) are considered.
Days' sales in receivables should reflect a business's credit terms, and the number of days to collection from clients.
Factors that inflate a valuation include extended collection periods for installment purchases or periods of sluggish sales, while those that deflate it include a large portion of customers paying quickly or a rapid sale cycle.

Current Assets: Inventories

Businesses hold inventory for sale during the normal course of business or production.
A trading concern uses a single inventory account, whereas a manufacturing firm has raw materials, work-in-process, and finished goods accounts.
Inventory Cost Flow Assumptions (FIFO, LIFO, Average Costs):
- FIFO (First-In, First-Out) assumes the first items in are the first ones out. The oldest costs are matched against current revenues, which can inflate profits during periods of inflation. Ending inventory reflects current costs, and low turnover distorts the approximation of replacement cost.
- LIFO (Last-In, First-Out) assumes the last items in are the first ones out. It matches the costs of the most recently acquired inventory against current revenues. Ending inventory valuation can be based on costs from several years or decades prior. During times of inflation, a lower profit results but a higher cash flow.
- Average cost determines a midpoint to calculate cost, resulting in an inventory amount and cost of goods sold somewhere between FIFO and LIFO. If inflation is present, inventory is higher than LIFO but lower than FIFO, and cost of goods sold is less than LIFO but greater than FIFO.

Current Assets: Prepayments

Prepayments are costs companies pay in advance for future use, usually within the operating cycle or one year.
They have minimal impact on short-term debt-paying ability as they do not generate a cash receipt.
Valued at the amount paid, they do not impact liquidity calculations.

Current Assets: Other

Assets included in this group are subject to cash realization or use during the business cycle.
Nonrecurring assets or those with significant potential might impact liquidity calculations.
Examples include property held for sale and advances or deposits.

Current Liabilities

Current liabilities are obligations that require liquidating resources expected to be met within one year.
Current assets and other current liabilities are part of this category.
Examples of common current liabilities include accounts payable (amounts owed), notes payable, accrued wages, accrued taxes, collections received in advance, and current portions of long-term debt.

Liquidity Ratios

Working capital is the difference between current assets and current liabilities.
The current ratio divides current assets by current liabilities and indicates ability to meet short-term obligations.
The acid-test (quick) ratio omits inventory, representing a more precise estimate of near-term liquidity.
The cash ratio is the most conservative measure, relating cash and marketable securities to current liabilities.
The sales-to-working-capital ratio measures the turnover of working capital per year.

Other Liquidity Considerations

Liquidity can be better than financial statements suggest due to unused credit lines, quick conversion of long-term assets to cash, and superior long-term debt management.
Liquidity can also be understated due to contingent liabilities, co-signing on another entity's debt, and recourse obligations.

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Description

This quiz covers Chapter 4 of Financial Reporting & Analysis, focusing on the liquidity of short-term assets and their impact on debt-paying ability. Explore key concepts such as current assets and the operating cycle in relation to a company's financial health.