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8-1 Notes
CHAPTER 8
WORKING CAPTIAL
I. Learning Objectives
1. Identify the principal components of working capital (other than accounts
receivable and advances from customers, discussed in Chapter 7, and
marketable securities, discussed in Chapter 12) and the business
transactions that give rise to each: cash, prepayments, inventory, accounts
payable, short-term notes, accrued liabilities (such as wages payable and
taxes payable), warranties, and restructuring liabilities.
2. Understand inventory components, inventory cost flows, and the
accounting for inventory in merchandising and manufacturing firms.
3. Understand the recognition and measurement of warranty liabilities and
restructuring liabilities.
II. Organization of Class Sessions
The coverage of the various topics in this chapter depends on the total
amount of class time that we devote to this chapter. When we devote one
hour of class time, we emphasize on the principal components of working
capital, understand the various business transactions. When we devote two
hours of class time, we understand the various inventory components, the
methods of inventory valuation and the transactions for inventory in
merchandising and manufacturing firms. Students should know the use of
inventory method that best suits the firm goal. Other important liabilities
include the warranty liability and the restructuring liability. The accounting
and the measurement of each should also be understood.
III. Lecture Outline
A. Identify the principal components of working capital (other than
accounts receivable and advances from customers, discussed in
Chapter 7, and marketable securities, discussed in Chapter 12)
and the business transactions that give rise to each: cash,
prepayments, inventory, accounts payable, short-term notes,
accrued liabilities (such as wages payable and taxes payable),
warranties, and restructuring liabilities.
Notes 8-2
Begin by reviewing the distinction between current assets and
liabilities and noncurrent assets and liabilities. The distinction refers to
whether a firm will convert an asset to cash, or consume it, or sell it
within one operating cycle and whether a firm will pay or otherwise settle
a liability within one operating cycle. Operating cycle for most firms is
one year or less, one year is the conventional cutoff for distinguishing a
current and a noncurrent asset or liability.
Working capital shows the liquidity of the firm. It is the difference
between a firm’s current assets and its current liabilities. The current
ratio, also called the working capital ratio, is current assets divided by
current liabilities. Emphasis the concept of current ratio and its
implications. Provide with examples of both the current assets and the
current liabilities and effect of the business transactions on various
accounts. The importance of working capital in an organization should be
explained.
Current assets include cash, accounts receivable (discussed in
Chapter 7), marketable securities (will be discussed in Chapter 12),
prepayments, and inventory. Current liabilities include accounts payable,
short-term notes payable, the current portion of long-term debt (will be
discussed in Chapter 10), advances from customers (discussed in Chapter
7), certain short-term accrued liabilities (such as wages payable and
taxes payable), the current portion of deferred taxes (will be discussed in
Chapter 11), certain short-term warranties, and the portion of
restructuring liabilities management expects to settle in the next year.
B. Understand inventory components, inventory cost flows, and the
accounting for inventory in merchandising and manufacturing
firms.
Start the session explaining the types of firms and how they classify
cost with respect to inventory. Students should know the primary
activity of merchandising firm and the items included in the acquisition
cost. Explain students the cost categories of manufactured inventories
and the diagram of cost flows; this will help the students in
understanding the various costs involved in a manufacturing unit. With
an example of a manufacturing unit, explain the process involved from
the purchase of raw materials till the sales of the finished goods. Explain
the costs involved at each stages of production.
Inventory measurements affect the income statement and the
balance sheet, which reports the carrying value of inventory at the end
of the reporting period. The sum of cost of goods sold and the ending
inventory balance must equal the sum of the beginning inventory
8-3 Notes
balance plus purchases or other acquisitions of inventory during the
period. The amount allocated to expense (cost of goods sold) and the
inventory asset (ending inventory balance) results in part from the firm’s
choices of the cost-flow assumption (FIFO, LIFO, and weighted average).
inventory. FIFO (the first-in, first-out cost-flow assumption) results in
balance sheet carrying values that approximate current cost. Students
should know the situations in which FIFO or LIFO is used in order to
achieve the organizations objective. We work with Problem 44 as it
provides a comparison of various choices for inventory accounting. This
will aid in understanding the concept more clearly. (Exercise 8.28, 8.29,
8.30, 8.31, Problem 8.39, 8.40, 8.41, 8.42, 8.43, 8.45, 8.46).
C. Understand the recognition and measurement of warranty
liabilities and restructuring liabilities
Ask students when they claim for the warranty of an i-pod they
purchased, what accounting treatment would be made by the firm for
the costs involved in replacing or repairing that i-pod. The cost is a part
of warranty liability. Explain students that firms provide warranty for
after sales services for certain period of time. Firms establish this likely
amount as warranty liability. Students should know that the accounting
for warranty liability, the computation of warranty expense for the
period.
Also, explain the students the definition of restructuring liabilities
and its scope. (Problem 8.48 and 8.49).
Notes 8-4
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