CHAPTER # 10

Current Assets
Current assets are assets which are expected to generate economic benefits within one year or
within the normal operating cycle of a business.

Current assets and non-current assets are the two categories into which all assets are classified
on a balance sheet. Information about current assets of a business is important because it helps
assess liquidity of a business when compared with current liabilities. Current assets are an
important input in calculation of current ratio and quick ratio.

Examples
Typical current assets include:

 Short-term prepayments
 Inventories
 Short-term notes receivable
 Accounts receivable
 Short-term investments
 Cash and cash equivalents

Short-term prepayments represent advance payments for expenses that are expected to be
incurred in the next twelve months.

Inventories are goods which are held by a business for the purpose of production or sale. These
include raw material, work-in-progress and finished goods.

Short-term notes receivables represent notes receivable that mature in twelve months.

Accounts receivable represent monies that are yet to be collected from customers. They are
presented on balance sheet net of any provision for doubtful debts.

Short-term investments represent investments which a business expects to sell within next

twelve months.

Cash and cash equivalents include cash in hand, cash at bank and all such financial instruments
which can be readily converted to cash without any significant loss of value.

Cash and Cash Equivalents

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Cash and cash equivalents refer to the sum of a company’s cash on hand, demand deposits, and
short-term highly liquid investments.

The following equation shows the composition of cash and cash equivalents:

Cash and Cash Equivalents = Cash on Hand + Demand Deposits + Short-term Investments

Cash refers to cash on hand and demand deposits. Demand deposits are the amounts held in
bank accounts which can be withdrawn right away.

Cash equivalents are short-term highly liquid investments which can be readily converted to
known amounts of cash and which carry an insignificant amount of risk of change in value. An
investment is cash equivalent only if it is primarily acquired with the objective of cash
management. They almost always have a very short maturity, say up to three months, and rarely
include equity investments.

Only under IFRS, bank overdrafts may sometimes be included in (subtracted from) cash and cash
equivalents if they are integral to a company’s cash management activities.

Cash and cash equivalents and statement of cash flows

The statement of cash flows prepared by a company reconciles its cash and cash equivalents
balance at the start of a period with their balance at the end of the period. The company may
either present cash and cash equivalents as a single line item on the statement of financial
position (in which case a breakup is shown in the notes) or separately as short-term investments
and cash.

As cash equivalents are considered part of cash, any conversion from cash equivalents to cash at
bank or from cash at bank to cash on hand is not reflected in the statement of cash flows as a
cash inflow or outflow. The statement of cash flows also shows the impact of movement in
foreign exchange rate on cash and cash equivalents held.

The cash and cash equivalents balance impacts a company’s cash ratio, the ratio of cash to
current liabilities; and current ratio, the ratio of current assets to current liabilities. A higher cash
ratio shows that the company is expected not to face any difficulty in paying its very short-term
liabilities.

Examples
1. A $20 million term deposit by a company for 1 month would qualify as a cash equivalent
because the maturity value is known and there is very low risk of change in value.
2. A saving deposit for 6 month would not qualify as a cash equivalent particularly if the
interest rate environment is volatile. This is because the duration involved and the

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 interest rate situation may cause the value of the investment to fluctuate between today
and the maturity date.
3. A company made a large payment from one of its bank accounts which is not the entity’s
primary bank account. This resulted in a negative balance in the bank account but the
company informed the bank that it would replenish the funds within a week. The
management does not expect the balance to turn negative again any time in near future.
This overdraft would most-likely not meet the definition of cash equivalents.
4. An investment today in preferred stock which is due to mature within 1 month is a cash
equivalent because the maturity value is known and there is low risk of change in value
during a week’s time.

Petty Cash
Petty cash fund is a relatively small amount of cash that businesses keep on hand for the
purpose of small transactions such as providing change to customers, postage expenses,
highway tolls etc. In such transactions, the use of checks is time consuming, costly or illogical.

Usually a custodian is appointed to administer the petty cash and it is his/her duty to account
for the expenses incurred out of petty cash fund. Whenever the custodian makes any payment
from the fund to an employee or a customer etc., he or she must record the amount being
disbursed, the name of the person to whom the payment is being made and the reason for the
disbursement.

Following are the typical transactions connected to petty cash fund.

1. Creation: Petty cash fund may be created by drawing a check on the company's

checking account and handing it over to the custodian of the fund. The journal entry is
to debit petty cash and credit cash at bank.
2. Disbursements: Individual disbursements from petty cash are not recorded via a journal
entry. Instead journal entry is passed at the time of each replenishment and at the end of
the period for the total amount disbursed.
3. Replenishment: When the balance in petty cash becomes low, a journal entry is passed
debiting various expense accounts and crediting petty cash for the sum of
disbursements made. Then petty cash is replenished usually via a check.
4. Raising Fund Level: When the volume of transactions to be handled by the petty cash
grows, the fund level is raised. The journal entry is to debit the petty cash and credit cash
at bank.

Example
Company A created a petty cash fund of $900 on Jan 1, 2012. The journal entry is:

Petty Cash 900

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 Cash at Bank 900
During January 2012, following disbursements were made from the fund:

Office
$300
Supplies
Highway Toll 50
Postage 30
Freight-In $350
The journal entry to record the about disbursements from petty cash is:

Office Supplies 300

Highway Toll 50
Postage 30
Freight-In 350
Petty Cash 730
The company replenished the fund via a check of $730. The journal entry is:

Petty Cash 730

Cash at Bank 730

Prepayments
Prepayments (also known as deferred expense) are assets that represents cash paid in advance
for goods or services to be received later. A prepayment is related to unearned income in a
sense that one company’s prepayment is other company’s unearned income.

The reason for deferral of expense is the accrual concept of accounting, which requires that an
expense must be recognized in the period to which it relates rather than in the period in which it
is paid for. Since prepayments are often made for goods or services, the receipt of which spans
over two or more accounting periods, prepayments must not be simply expensed on payment
date.

Prepayments are usually current assets but in extremely rare cases they may span over 12
months after year end, in which case they are classified as non-current assets.

Journal Entries
Accounting for prepayments involves the following journal entries:

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 1. A prepayment transaction is recorded initially by debiting an asset account (such as
prepaid insurance, prepaid rent etc.) and crediting cash or bank.
2. At the end of each accounting period an adjusting entry is passed that debits expense
and credits prepaid asset for the part of goods or services which have been received in
that period.

Example
On April 1, 20X5, Company β pays $40,00 for twelve month insurance in advance. Company β’s
financial year ends on June 30, 20X5.

Required:
(1) Journal entries to account for the above transaction on April 1, 20X5 and June 30, 20X5.
(2) Balance in prepaid insurance account on June 30, 20X5.

Solution

April 1, 20X5: To record the prepayment as a current asset:

Prepaid Insurance 40,000

Bank 40,000
June 30, 20X5: To record insurance expense for three months [=40000×3/12].

Insurance Expense 10,000

Prepaid Insurance 10,000
Balance in Prepaid Subscriptions on June 30, 20X5: $400 – $100 = $300

Bank Overdraft
When a business' bank account has a negative balance it is said to be running a bank overdraft
(more precisely an actual bank overdraft). It is a form of financing in which the bank honors
presented checks even when there is no balance in the business account which results in
negative balance in the bank account.

There is a special type of bank overdraft called 'book bank overdraft' which represent situation
in which the balance as per cash book is negative while the balance as per bank book is positive.
It arises when the checks written exceed the bank balance available thereby resulting in negative
bank balance in books but since those checks are not yet presented so the bank balance is not
negative and there is no 'actual bank overdraft'.

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Balance sheet treatment of bank overdraft
When the bank has a right to offset the overdraft balance with another bank account of the
business, the overdraft is netted off against the other bank accounts maintained with the same
bank and the net bank balance is shown as the balance of cash at bank.

When the bank has no such right to offset, the overdraft is reported as a liability and when it is
material it should be reported separately from other liabilities.

Bank overdraft and statement of cash flows

For the purpose of statement of cash flows, under US GAAP any changes in bank overdrafts for a
period are appropriately reported as a cash flows from financing activities.

Under IFRS however, bank overdraft is treated as part of cash and cash equivalents and
movement in bank overdraft is not reported anywhere in the statement of cash flows.

Example
Earth Inc. has four bank accounts: Account A and B which are maintained at Mars Bank. A has a
balance of $20 million while B has an overdraft of $2 million. Account C and D are maintained at
Venus Bank. C has a balance of $50 million and D has a balance of -$10 million. On Mars, banks
are entitled to set off any negative bank balances with positive balances while Venetian banks
have no such luxury. Earth applies US GAAP and Account B and D has no balance at the start of
the year. Comment on balance sheet and statement of cash flows presentation of the overdraft.

Solution

On its balance sheet, Earth Inc. shall report cash and cash equivalents of $68 million ($20 million
in Account A minus $2 million in Account B plus $50 million in Account C). It will show a
corresponding bank overdraft liability of $10 million.

On its statement of cash flows, it shall report a cash inflow from 'changes in overdrafts' of $10
million under cash flows from financing activities.

Bank Reconciliation
A company's cash balance at bank and its cash balance according to its accounting records
usually do not match. This is due to the fact that, at any particular date, checks may be
outstanding, deposits may be in transit to the bank, errors may have occurred etc. Therefore
companies have to carry out bank reconciliation process which prepares a statement accounting
for the difference between the cash balance in company's cash account and the cash balance
according to its bank statement.

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Following are the transactions which usually appear in company's records but not in the bank
statement:

 Deposits in Transit: Deposits which have been sent by the company to the bank but
have not been received by the bank at proper time before the issuance of bank
statement.
 Checks Outstanding: Checks which have been issued by the company but were not
presented or cleared before the issuance of bank statement.

Following are the transactions which usually appear in bank statement but not in company's
cash account:

 Service Charges: Service charges may have been deducted by the bank. Such charges
are usually not known to the company before the issuance of bank statement.
 Interest Income: If any interest income has been earned by the company on its bank
account, it is not usually entered in company's cash account before the issuance of bank
statement.
 NSF Checks: NSF stands for "not sufficient funds". These are the checks deposited by the
company in bank account but the bank is unable to receive payment on those checks
due to insufficient funds in the payer's account.

Example
Company A's bank statement dated Dec 31, 2011 shows a balance of $24,594.72. The company's
cash records on the same date show a balance of $23,196.79. Following additional information is
available:

1. Following checks issued by the company to its customers are still outstanding:

No. 846 issued on Nov

$320.00
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No. 875 issued on Dec 26 49.21

No. 878 issued on Dec 29 275.00

No. 881 issued on Dec 31 186.50

2. A deposit of $400.00 made on Dec 31 does not appear on bank statement.

3. An NSF check of $850 was returned by the bank with the bank statement.
4. The bank charged $50 as service fee.
5. Interest income earned on the company's average cash balance at bank was $1,237.22.

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 6. The bank collected a note receivable on behalf of the company. Amount received by the
bank on the note was $550. This includes $50 interest income. The bank charged a
collection fee of $10.
7. A deposit of $430 was incorrectly entered as $340 in the company's cash records.

Prepare a bank reconciliation statement using the above information.

Solution:

Company A
Bank Reconciliation
December 31, 2011
 
Balance as per Bank, Dec 31 $24,594.72
Add: Deposit in Transit 400.00
$24,994.72
Less: Outstanding Checks:
No. 846 issued on Nov 29 $320.00
No. 875 issued on Dec 26 49.21
No. 878 issued on Dec 29 275.00
No. 881 issued on Dec 31 186.50
830.71
Adjusted Bank Balance $24,164.01
 
Balance as per Books, Dec 31 $23,196.79
Add:
Interest Income from Bank $1,237.22
Note Receivable Collected by Bank 500.00
Interest Income from Note
50.00
Receivable
Deposit Understated 90.00
1,877.22
$25,074.01
Less:
NSF Check 850.00
Bank Service Fee 50.00
Bank Collection Fee 10.00
910.00
Adjusted Book Balance $24,164.01

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Prepaid Expense
d expense (also called prepayment) is an asset which arises when a business pays an expense in
advance.

In accordance with the matching principle, the advance payment is not recorded as an expense
at the time of payment because it relates to future expenses. It is recorded as an asset initially
and written-off as expense through an adjusting entry when the expense is actually incurred.

Prepaid expenses are reported on a balance sheet as a current asset when they relate to
expenses that are expected to be incurred within the next 12 months and non-current
asset otherwise.

Common prepaid expenses include prepaid rent, prepaid utilities expense, prepaid lease rentals,
etc.

Journal entries
When a payment is made for a future expense, the following journal entry is made:

Prepaid expense ABC

Bank ABC
As the related expense is incurred, prepaid expense is written off proportionately as follows:

Expense DEF
Prepaid expense DEF
Example
PMTA, Inc. is a leading financial services IT company which recently entered into a 10-year
contract for a 2-storey space in a leading IT business hub and paid 3 years rent in advance on 1
July 2015 which amounted to US$ 9,000,000.

The company’s financial year ends on 31 December. Journalize the transactions in the books of
PMTA, Inc.

The payment of 3 years rent in advance can’t be recorded as expense because it spans more
than 3 accounting periods and the generally accepted accounting principles don’t allow such an
accounting treatment. Instead, it is recorded as an asset initially:

Prepaid rent $9,000,000

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 Bank $9,000,000
At the end of the financial year, an adjusting entry is made to recognize rent expense for the
period for which the building has been used. The expense is recognized on proportionate basis
i.e. monthly rent is calculated by dividing the total rent for 3 years (which is $9,000,000) by total
number of months in the period (i.e. 36), and multiplying it by the total number of months for
which the company has used the building (which is 6).

Rent expense
$1,500,000
($9,000,000/36*6)
Prepaid rent $1,500,000
Prepaid rent is presented on the balance sheet as at 31 December 2015 as follows:

 An amount of $3,000,000 appear as ‘prepaid expenses’ in the current assets section,

representing the prepayment that relates to next twelve months.
 An amount of $4,500,000 [= 9,000,000 – 1,500,000 – 3,000,000] appear under non-
current assets section, representing the prepaid rent that is expected to be consumed in
the period after next 12 months.

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