Current assets

Current assets generally include all of the following:

• Cash available for current operations and items that are cash equivalents
• Inventories of merchandise, raw materials, goods in process, finished goods, operating supplies, and ordinary maintenance material and parts
• Trade accounts, notes, and acceptances receivable
• Receivables from officers, employees, affiliates, and others if collectible in the ordinary course of business within a year
• Installment or deferred accounts and notes receivable if they conform generally to normal trade practices and terms within the business
• Marketable securities representing the investment of cash available for current operations
• Prepaid expenses such as insurance, interest, rents, taxes, unused royalties, current paid advertising service not yet received, and operating supplies

Prepaid expenses are not current assets in the sense that they will be converted into cash; rather, prepaid expenses are current assets in the sense that, if not paid in advance, they would require the use of current assets during the operating cycle.

A one-year time period is used as a basis for the segregation of current assets in cases where there are several operating cycles occurring within a year. However, if the period of the operating cycle is more than 12 months, as in, for instance, the tobacco, distillery, and lumber businesses, the longer period should be used. If a particular entity has no clearly defined operating cycle, the one-year rule should apply.

The concept of current assets excludes the following:

• Cash and claims to cash that are restricted as to withdrawal or use for other than current operations, are designated for expenditure in the acquisition or construction of noncurrent assets or are segregated for the liquidation of long-term debts. Even though not actually set aside in special accounts, funds that are clearly to be used in the near future for the liquidation of long-term debts, payments to sinking funds, or for similar purposes should also, under this concept, be excluded from current assets. However, if such funds are considered to offset maturing debt that has properly been set up as a current liability, they may be included within the current asset classification.
• Investments in securities (whether marketable or not) or advances that have been made for the purposes of control, affiliation, or other continuing business advantage
• Receivables arising from unusual transactions (such as the sale of capital assets, or loans or advances to affiliates, officers, or employees) that are not expected to be collected within 12 months
• Cash surrender value of life insurance policies
• Land and other natural resources
• Depreciable assets
• Long-term prepayments that are fairly chargeable to the operations of several years, or deferred charges such as bonus payments under a long-term lease, costs of rearrangement of factory layout, or removal to a new location

Current liabilities

Total current liabilities should be presented in classified balance sheets. The concept of current liabilities includes estimated or accrued amounts that are expected to be required to cover expenditures within the year for known obligations the amount of which can be determined only approximately (as in the case of provisions for accruing bonus payments) or where the specific person or persons to whom payment will be made cannot as yet be designated (as in the case of estimated costs to be incurred in connection with guaranteed servicing or repair of products already sold). The following transactions may result in current liability classification:

• Due on demand loan agreements
• Callable debt agreements
• Short-term obligations expected to be refinanced

The classification of current liabilities generally includes obligations for the following items that have entered into the operating cycle:

• Payables incurred in the acquisition of materials and supplies to be used in the production of goods or in providing services to be offered for sale
• Collections received in advance of the delivery of goods or performance of services (Examples of such current liabilities are obligations resulting from advance collections on ticket sales, which will normally be liquidated in the ordinary course of business by the delivery of services. On the contrary, obligations representing long-term deferments of the delivery of goods or services would not be shown as current liabilities. Examples of the latter are the issuance of a long-term warranty or the advance receipt by a lessor of rental for the final period of a 10-year lease as a condition to execution of the lease agreement.)
• Debts that arise from operations directly related to the operating cycle, such as accruals for wages, salaries, commissions, rentals, royalties, and income and other items

The following other liabilities whose regular and ordinary liquidation is expected to occur within a relatively short period of time, usually 12 months, are also generally included in current liabilities:

• Short-term debts arising from the acquisition of capital assets
• Serial maturities of long-term obligations
• Amounts required to be expended within one year under sinking fund provisions
• Agency obligations arising from the collection or acceptance of cash or other assets for the account of third persons

Presentation of income tax effects

An entity should present components of other comprehensive income in the statement in which OCI is reported 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.

An entity should present the amount of income tax expense or benefit allocated to each component of OCI, including reclassification adjustments in the statement in which those components are presented or disclose it in the notes to the financial statements.

Accumulated other comprehensive income

The total of OCI for a period should be transferred to a component of equity that is presented separately from retained earnings and additional paid-in capital in a statement of financial position at the end of an accounting period. A descriptive title such as accumulated other comprehensive income should be used for that component of equity.

An entity should present, on the face of the financial statements or as a separate disclosure in the notes, the changes in the accumulated balances for each component of OCI included in that separate component of equity. The presentation of changes in accumulated balances should correspond to the components of OCI in the statement in which OCI for the period is presented.

Reclassification adjustments

Reclassification adjustments should be made to avoid the double counting of items in comprehensive income that are presented as part of net income for a period that also had been presented as part of OCI in that period or earlier periods.

An entity should determine reclassification adjustments for each component of OCI, except for a reclassification adjustment for foreign currency translation adjustments limited to translation gains and losses realized upon sale or upon complete or substantially complete liquidation of an investment in a foreign entity.

An entity should determine only reclassification adjustments for amounts recognized in OCI related to other-than-temporary impairments of debt securities classified as held-to-maturity if the loss is realized as a result of a sale of the security or an additional credit loss occurs.

An entity may present reclassification adjustments out of accumulated OCI on the face of the statement in which the components of OCI are presented, or it may disclose those reclassification adjustments in the notes to the financial statements. Therefore, for all classifications of OCI, an entity may use either a gross display on the face of the financial statement or a net display on the face of the financial statement and disclose the gross change in the notes to the financial statements. If displayed gross, reclassification adjustments are reported separately from other changes in the respective balance; therefore, the total change is reported as two amounts. If displayed net, reclassification adjustments are combined with other changes in the OCI balance; therefore, the total change is reported as a single amount.

The operating section

• This section is concerned with cash items that have an effect on the income statement.
• Uses either a gross (direct method) or net (indirect method) cash flow approach in its preparation. FASB encourages the use of the direct method.
• Direct method required minimum disclosures include the following (more detailed disclosures are permissible):
  • Cash from customers
  • Cash from interest and dividends
  • Cash from other operating activities
  • Cash paid to suppliers and employees
  • Cash interest paid
  • Cash paid for income taxes
  • Cash payments for other operating items
• Indirect method disclosures include noncash items to convert accrual basis income to cash income such as these:
  • Deferrals of operating cash receipts and payments (such as those for inventory and unearned revenues)
  • Accruals of operating cash receipts and payments (such as those for receivables and payables)
  • Adjustments for gains and losses where the cash flows are reflected in the investing or financing sections (such as sale of capital assets, or debt extinguishment)
• The cash provided by operations computed by the indirect method will always equal the amount that would have been reported if the direct method had been used. Adjustments for changes in items such as accounts receivable and payable should be made after the elimination of the changes in these accounts related to investing and financing activities.
• When the indirect method is used, the amount of interest and income taxes paid during the accounting period must be separately disclosed.
• When the direct method is used, a reconciliation of net income to cash provided by operations (in effect the indirect method) must be separately disclosed.

The investing section

• This section is concerned with inflows and outflows that are of an investing nature.
• It includes nonoperating cash flows that relate to the asset side of the balance sheet.
• Investing cash inflows include
  • cash from sale of property, plant, and equipment, and other productive assets;
  • cash from sale of equity instruments of other entities;
  • cash from the sale of debt instruments of other entities purchased by the company;
  • cash from collections or sale of loans made by the company; and
  • insurance proceeds relating to transactions classified as investing.
• Investing cash outflows include
  • cash payments to acquire property, plant, and equipment, and other productive assets; payment must be made at the time of purchase or shortly thereafter;
  • cash payments for acquisition of equity instruments of other companies; and
  • cash payments for acquisition of debt instruments of other companies.
• The following cash receipts and payments are excluded from the investing section of the statement of cash flows and are included in the operating section:
  • Receipts and payments from the buying and selling of debt and equity securities of other entities carried at fair market value in a trading account for the primary purpose of resale to customers
  • Receipts and payments from the origination or buying and selling of loans, carried at either fair market value or lower of cost or market, acquired for resale

The financing section

• This section is concerned with cash flow items that are of a financing nature.
• It includes nonoperating cash flows that relate to the liability and shareholders’ equity side of the balance sheet.
• Financing cash inflows include the following:
  • Cash from issuing equity instruments
  • Cash from short-term and long-term debt such as bonds and notes
  • Receipts from contributions and investment income that by donor stipulation are restricted for the purposes of acquiring, constructing, or improving property, plant, equipment, or other long-lived assets, or establishing or increasing a permanent endowment or term endowment
  • Proceeds received from derivative instruments that include financing elements at inception, whether the proceeds were received at inception or over the term of the derivative instrument, other than a financing element inherently included in an at-the-market derivative instrument with no prepayments
  • Cash retained as a result of the tax deductibility of increases in the value of equity instruments issued under share-based payment arrangements that are not included in the cost of goods or services that is recognizable for financial reporting purposes (for this purpose, excess tax benefits should be determined on an individual award [or portion thereof] basis)
• Financing cash outflows include the following:
  • Cash payments of dividends or other distributions to owners. Cash paid to a tax authority by an employer when withholding shares from an employee’s award for tax-withholding purposes shall be considered an outlay to reacquire the entity’s equity instruments.
  • Cash payments to reacquire equity instruments
  • Cash repayments of borrowed amounts
  • Cash payments to creditors who have extended long-term credit
  • Distributions to counterparties of derivative instruments that include financing elements at inception, other than a financing element inherently included in an at-the-market derivative instrument with no prepayments (the distributions may be either at inception or over the term of the derivative instrument)
  • Payments for debt issue costs

Gross amounts versus net amounts

For most purposes, gross cash inflows and gross cash outflows are used in the preparation of the statement of cash flows. Gross amounts are assumed to be more relevant than net cash flows. Net cash flows may be used instead of gross cash flows in the following situations:

• The indirect method (in place of the direct method) when calculating cash flows related to operations
• Items with quick turnovers, large amounts, and short maturities, such as
  • cash flows associated with the purchase and sale of cash equivalents;
  • cash flows associated with loans receivable, demand deposits of banks, and deposits placed by them in other institutions; and
  • cash flows pertaining to investments and cash flows related to debt with an original maturity of three months or less.

Classification decision rule

Cash flows should follow the nature of the cash flow item instead of the purpose of the transaction. For example, a purchase of Treasury stock will always be classified as a financing cash outflow even if the stock is used for the purpose of providing compensatory stock options for employees. The purpose of the stock option purchase is to compensate employees, not to reduce stockholder’s equity; therefore, it can be thought of as an operating transaction even though it is classified in the financing section of the statement of cash flows.

Noncash investing and financing activities

Transactions that represent significant financing or investing activities but do not increase or decrease cash (as well as cash equivalents) are required to be disclosed. What constitutes significant noncash investing and financing activity is a matter of judgment. Examples of noncash investing and financing activities that should be disclosed include the following:

• Asset acquired by assuming liabilities, including capital lease obligations
• Stock issued for noncash consideration
• Acquisition of an entity in exchange for stock
• Conversion of debt to equity or one class of stock to another
• Noncash dividends
• Unrealized gains or losses on marketable equity securities

The two methods of disclosure are (1) supplemental display and (2) footnote. The supplemental display can be shown either as a narrative or a schedule. A footnote can appear as either a separate cash flow footnote or distributed to the appropriate topical footnote to the financial statements. An example of the latter would be explaining the noncash portion of a capital lease transaction.

Discontinued operations

FASB ASC 205-20-50 calls for disclosure, in specified circumstances, of the total operating and investing cash flows of the discontinued operation for the period(s) reported. Additionally, there are cash flow disclosure requirements for significant continuing involvement with a discontinued operation.

Direct and indirect presentation of operating activities

The operating section may be prepared using a direct or an indirect approach. Either approach will result in the same amount of cash provided from operations. Cash flow from operations must be clearly displayed in the statement and must be reconciled to net income.

The direct approach

• Preferred by FASB
• Uses gross cash operating inflows and outflows
• Shows gross operating cash receipts and cash payments, and provides information about the source of receipts and the nature of the operating cash payments
• Requires a reconciliation of accounting income to cash provided from operations (identical with the indirect method) resulting in direct linkage to the income statement

FASB requires minimum categories of cash flow reporting, but encourages companies to provide additional breakdowns of operating cash inflows and outflows. For example, FASB suggests that a retailer might want to further subdivide cash paid to employees and suppliers into payments for inventory and payments for selling, general, and administrative expense.

The indirect approach

• Begins with net income as opposed to income from operations
• Adds noncash expenses, deducts noncash revenues from book income, and adjusts book income for changes in related current balance sheet accounts to calculate cash from operations
• Adds credit changes to balance sheet accounts that relate to the income statement
• Subtracts debit changes to balance sheet accounts that relate to the income statement
• Reconciles financial accounting income to net cash flows from operations
• Requires an additional disclosure of cash paid for taxes and cash paid for interest