14

Working
Capital

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Learning Objectives
In this chapter, you will:
1. Identify the principal components of
working capital (other than accounts
receivable and advances from customers
and marketable securities) and the
transactions that give rise to each
component. Components include cash,
prepayments, inventory, accounts payable,
short-term notes, accrued liabilities (such
as wages payable and taxes payable),
warranties, and restructuring liabilities.
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Learning Objectives
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.

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Underlying Concepts &

Terminology
Working capital: Difference between
current assets and current liabilities
Current ratio: Current assets divided
by current liabilities
Working capital and the current ratio
provide information about liquidity
Negative working capital does not
mean a firm cannot meet its near-term
obligations
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Principal Current Asset

Accounts
Cash and cash equivalents
Cash: Includes currency, money orders,
bank checks, checking accounts, and time
deposits
Cash equivalents: Refer to liquid shortterm assets in which the firm has
temporarily invested excess cash

Prepayments
Represent services a firm has paid for
before consuming them
Also called prepaid assets
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Principal Current Asset

Accounts
Inventory
Items a firm holds for sale or for further
processing as part of its operations
When it is sold, the carrying amount
becomes an expense, Cost of Goods Sold
Three issues in inventory accounting
Types of costs included in acquisition cost
Treatment of changes in the market value
Cost-flow assumptions used to trace the
movement of costs

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Inventory Terminology
Inventory: The stock of goods a firm holds for
sale or for further processing
Raw materials inventory: The inventory of
materials stored that are used in production.
Work-in-process: An inventory of partially
completed goods
Finished goods inventory: Measures the
manufacturing cost of units completed but not
yet sold
Cost of Goods Sold: An expense reducing
net income and ultimately retained earnings
7
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Inventory Equation
Describes changes in inventory
Goods available for use or
sale
Goods available for use or
sale

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Costs Included in
Inventory
Should include all costs incurred to
acquire goods and prepare them for
sale
Manufacturing firms incur three types of
costs to convert raw materials into
finished goods
Direct materials: Cost of materials traced
directly to units of product manufactured
Direct labor: Cost of labor to transform
raw materials into finished product
Manufacturing overhead: Costs which
are not easily identified with the product 9
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Diagram of Cost Flows

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10

Flow of Manufacturing Costs

Through the Accounts

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11

Inventory Accounts
Kendrick Inc. reported the following beginning
and ending inventory balances for the year ended
Sept. 30, 2013:
Beginning Ending
Raw Materials
340
562
Work in Process
132
231
Finished Goods
714
562
During fiscal 2012, Kendrick purchased $867 in
raw materials, used $674 of labor, and charged
overhead costs at a rate of twice labor costs
Lets calculate the following: (1) Raw materials
used in production, (2) Overhead costs used in
production,
(3) Cost ofLearning
units completed, and (4)
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2013 South-Western/Cengage

12

Inventory Accounts
Below are all the balances given in the
problem:
Raw Materials
Work in Process
Beg. Bal.

340

Purchases

86
7

End. Bal.

Beg. Bal.
Labor
Used
Materials
Used
Overhead
Used
End. Bal.

562

132
674
?
?

231

Finished Goods
Beg. Bal.
Goods
Completed
End. Bal.

714
?

COG
S

562

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13

Inventory Accounts
Below are all the balances given in the
Beg. Balance
+ in Process
problem:
Raw Materials
Work
Beg. Bal.

340

Purchases

86
7

End. Bal.

Purchases End.
Beg. Bal.
132
Balance = Raw
Labor
674
materials
used
in
Used
Materials
?
?
production
Used
Overhead
?
$340
Used+ $867 $562
Bal.
231
=End.
$645

645

562

Finished Goods
Beg. Bal.
Goods
Completed
End. Bal.

714
?

COG
S

562

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14

Inventory Accounts
Below are all the balances given in the
problem:
Raw Materials
Work in Process
Beg. Bal.

340

Purchases

86
7

End. Bal.

Beg. Bal.
Labor
Used
Materials
Used
Overhead
Used
End. Bal.

645

562

132
674
64
5
?

231

Finished Goods
Beg. Bal.
Goods
Completed
End. Bal.

714
?

COG
S

562

COPYRIGHT 2013 South-Western/Cengage Learning

15

Inventory Accounts
Below are all the balances given in the
problem:
Raw Materials
Work in Process
Beg. Bal.

340

Purchases

86
7

End. Bal.

Beg. Bal.
Labor
Used
Materials
Used
Overhead
Used
End. Bal.

645

562

132
674
64
5
1,34
8
231

Finished Goods
Beg. Bal.
Goods
Completed
End. Bal.

714
?

COG
S

Overhead used
In Production =
2 Labor = 2
$674 = $1,348

562

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16

Inventory Accounts
Below are all the balances given in the
problem:
Raw Materials
Work in Process
Beg. Bal.

340

Purchases

86
7

End. Bal.

645

562

Beg. Bal.
Labor
Used
Materials
Used
Overhead
Used
End. Bal.

132
674
64
5
1,34
8
231

2,568

Finished
GoodsUsed +
Beg. Balance
+ Labor
Materials
Used
Beg.
Bal.
714 + Overhead
Used End. Balance = Cost of
Goods
?
?
COG
Units Completed
Completed

$132 + $674 + $645 + 1,348

562
231 = $2,568

End. Bal.

COPYRIGHT 2013 South-Western/Cengage Learning

17

Inventory Accounts
Below are all the balances given in the
problem:
Raw Materials
Work in Process
Beg. Bal.

340

Purchases

86
7

End. Bal.

Beg. Bal.
Labor
Used
Materials
Used
Overhead
Used
End. Bal.

645

562

132
674
64
5
1,34
8
231

2,568

Finished Goods
Beg. Bal.
Goods
Completed
End. Bal.

714
2,56
8

COG
S

562

COPYRIGHT 2013 South-Western/Cengage Learning

18

Inventory Accounts
Below are all the balances given in the
problem:
Raw Materials
Work in Process
Beg. Bal.

340

Purchases

86
7

End. Bal.

Beg. Bal.
Labor
Used
Materials
Used
Overhead
Used
End. Bal.

645

562

Finished Goods
Beg. Bal.
Goods
Completed
End. Bal.

714
2,56
8

2,720

562

COPYRIGHT 2013 South-Western/Cengage Learning

COG
S

132
674
64
5
1,34
8
231

2,568

Beg. Balance +
Goods
Completed
End. Balance =
Cost of Goods
Sold
$714 + $2,568
562 = $2,720
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Valuation Subsequent to
Acquisition
U.S. GAAP and IFRS require inventories
to be initially recorded at acquisition
cost
Neither U.S. GAAP nor IFRS permit firms
to remeasure inventories upward to an
amount exceeding their acquisition cost
Both U.S. GAAP and IFRS require firms
to write down the carrying value of
inventories when their market value
declines below acquisition cost
Inventory is referred to as impaired and
COPYRIGHT 2013 South-Western/Cengage Learning
valuation is referred as lower-of-cost-or-

20

Summary of the Effects of

Inventory Remeasurements
Inventory remeasurement rules
determine when the gain or loss on the
inventory should appear in the financial
statements
Income in the period of an inventory
write-down will be lower than if the firm
had used the acquisition cost basis:
But income in a later period, when the firm
sells the inventory, will be higher

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21

Cost-Flow Assumptions
Neither U.S. GAAP nor IFRS requires
firms to use specific identification
Both allow firms to select a cost-flow
assumption

Cost-flow assumption need not match

the actual physical flow of units within
the firm
Typical cost-flow assumptions are as
follows:
1. Weighted average
2. First-in first-out (FIFO)
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3. Last-in first-out (LIFO)

22

Weighted-Average Cost-flow
Assumption
Calculates the average of the costs of
all units available for sale during the
accounting period
Applies to the units sold during the
period and to the units on hand at the
end of the period

COPYRIGHT 2013 South-Western/Cengage Learning

23

First-in First-out Cost-flow

Assumption
Assigns the costs of earliest units
acquired to the units sold and assigns
the costs of the most recent
acquisitions to the ending inventory

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24

Last-in First-out Cost-flow

Assumption
Assigns the costs of the latest units
acquired to the withdrawals and assigns
the costs of the oldest units to the
ending inventory
Prohibited by IFRS

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25

Comparison of and Choice

among Cost-Flow Assumptions
FIFO results in balance sheet figures
that are closest to current cost
LIFO ending inventory can contain costs
of items acquired many years
previously
When inventory price rises FIFO results
in higher net income than LIFO
Weighted-average cost-flow assumption
falls between the other two in its effects
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26

Analyzing Inventory
Disclosures
Increasing cost of goods sold
percentage and increasing inventory
turnover ratio results in a lower profit
margin and an increased total asset
turnover
Effect on ROA depends on which effect
dominates

Decreasing cost of goods sold

percentage and increasing inventory
turnover ratio increase both the profit
margin and the total assets turnover
This increases ROA

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27

Analyzing Inventory
Disclosures
Increasing cost of goods sold
percentage and decreasing inventory
turnover ratio decreases both the profit
margin and the total asset turnover
This lowers ROA

Decreasing cost of goods sold

percentage and decreasing inventory
turnover ratio increases the profit
margin but decreases the total asset
turnover
Effect on ROA depends on which effect
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2013 South-Western/Cengage Learning
dominates

28

Principal Current Liability

Accounts
Accounts payable
Deferred payment for items purchased from
suppliers

Short-term notes and interest payable

Finance obtained for less than a year from
banks or other lenders by signing a shortterm note payable

Wages, salaries, and other payroll items

Amount owed for the work done prior to the
last day of fiscal year
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29

Principal Current Liability

Accounts
Income taxes payable
Amount of taxes payable to the taxing
authority

Product warranties
Liabilities from agreements to provide a
warranty for service or repairs for some
period after a sale the

Restructuring liabilities
U.S. GAAP and IFRS require that firms
estimate the costs of a restructuring effort
and record this estimate as an expense,
with an associated restructuring liability or
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provision

30

Appendix 9.1: LIFOs Effects

on Financial Statements
Amount added to inventory in a year
when purchases exceed sales is called a
LIFO inventory layer
U.S. firm using LIFO must consider
issues of dipping into old LIFO layers of
inventory, also called LIFO liquidation

31
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Appendix 9.1: LIFOs Effects

on the Financial Statements
Reducing end-of-period physical
inventory quantities below beginning
quantities causes:
Cost of goods sold to reflect the current
periods purchases plus portion of older
beginning inventory
Results in larger reported income and larger
income taxes

SEC registrants using LIFO must

disclose LIFO reserve
Excess of FIFO or current cost over LIFO
cost of inventories
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32

Appendix 9.1: LIFO-FIFO

Choice
Depends on several factors:

Extent of changes in manufacturing costs

Rate of inventory turnover
Direction of expected changes in costs
Relative emphasis on reporting higher
earnings to shareholders versus saving
income taxes
Increased record-keeping costs of LIFO
Requirement that U.S. firms must use LIFO
for financial reporting if they use LIFO for
income tax reporting
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33

End of Chapter 9

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