Current Assets Explained | CFA Level I FSA

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

We shall discuss the individual items of a typical balance sheet, starting with current assets.

Components of Current Assets

Current assets include cash and other assets that will be converted into cash or used up within one year, or operating cycle, whichever is greater. Common items classified under current assets include:

• Cash and cash equivalents
• Marketable securities
• Accounts receivable
• Inventories
• Prepaid expenses

Cash and Cash Equivalents

Cash equivalents are short-term, highly liquid investments that are readily convertible to cash. It is likely to be close to maturity that interest rate risk is insignificant. Examples of cash equivalents include Treasury bills, commercial paper, and money market funds. Cash and equivalents are considered financial assets. Generally, financial assets are reported on the balance sheet at amortized cost or fair value. For cash equivalents, either measurement base should result in about the same value.

Marketable Securities

Marketable securities are financial assets that are traded in a public market, and whose value can be readily determined. Securities which the company expects to liquidate within 1 year, or 1 operating cycle are classified under current assets. Examples include Treasury notes, bonds, and equity securities. Marketable securities can be reported at amortized cost or fair value. They will be discussed in the next lesson under non-current assets.

Accounts Receivable

Accounts receivable are amounts owed to the company by customers for goods or services sold on credit. They are reported at net realisable value, taking into account an estimated bad debt expense. Bad debt expense is the allowance for doubtful accounts.

The accounts receivable is the gross receivables less the allowance for doubtful accounts. When receivables are removed from the balance sheet because they are uncollectible, both gross receivables and the doubtful account are reduced.

Firms are required to disclose significant concentrations of credit risk, including customer, geographic, and industry concentrations.

Analysing receivables relative to sales can reveal collection problems. The allowance for doubtful accounts should also be considered relative to the level and growth rate of sales. Firms can underestimate bad debt expense, thereby increasing reported earnings.

Inventories

Inventories can be reported separately as raw materials, work-in-process, and finished goods.

The costs included in inventory include purchase cost, conversion costs, and other costs necessary to bring the inventory to its present location and condition.

Costs that are excluded from inventory include:

• Abnormal amounts of wasted materials, labor, and overheads
• Storage costs, unless they are necessary as a part of the production process
• Administrative overhead and selling costs

There are 2 common ways to measure inventory cost:

1. Standard costing, often used by manufacturing firms, involves assigning predetermined amounts of materials, labor, and overhead to goods produced
2. The retail method, in which the retail value is reduced by the gross margin to calculate cost

Under IFRS, inventories are reported at the lower of cost or net realisable value.

Net realisable value is the estimated selling price less the estimated cost of completion and selling costs.

Under US GAAP, inventories are reported at the lower of cost or market value.

Market value is usually equal to replacement cost; however, market cannot be greater than net realizable value or less than net realizable value less a normal profit margin.

Other Current Assets

Other current assets are amounts that may not be material if shown separately; thus, the items are combined into a single amount.

One common example is prepaid expenses. Prepaid expenses are operating costs that have been paid in advance. For example, the company pays the supplier before the supplier delivers the goods. This is recorded in the company’s balance sheet as a prepaid expense under assets.

When the supplier eventually delivers the goods, the costs are actually incurred.

An expense is recognized in the income statement, and the prepaid expenses account decreases by that amount.

Up next, we move on to current liabilities. See you!