Level 1 CFA® Exam:
Current Assets and Liabilities
In this lesson, we will focus on current assets and liabilities, and specifically on the following types:
- assets – cash and cash equivalents,
- assets – marketable securities,
- assets – accounts receivable,
- assets – inventories,
- assets – other current assets,
- liabilities – accounts payable and financial liabilities,
- liabilities – accrued expenses and deferred income.
Current assets are the ones that the company is going to use within one year.
Below, we discuss the most common types of current assets that the readers of financial statements can encounter.
Cash and Cash Equivalents
Cash and cash equivalent are considered the most liquid financial assets on the company’s balance sheet. Generally, accounting standards assume that the company will be able to use them within the next three months since the balance sheet presentation date.
Accounting standards allow two separate valuation methodologies for cash and cash equivalent assets:
- amortized cost or,
- fair value.
The amortized cost recognition methodology requires the assets to be valued using the historical cost of an asset (when the asset has been acquired or generated) adjusted for amortization and any impairment charges to its value.
The fair value method requires assets to be reported at the value that the company could receive if the assets were exchanged or sold on the market.
Both IFRS and U.S. GAAP provide a specific definition of the fair value of the asset (or liability):
fair value – the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date
Because cash and cash equivalents value is highly observable and no material adjustments or impairment charges to those positions are expected, valuation should not substantially differ under these two methods.
Accounts receivables, aka. trade receivables, represent the money for sales and delivery of the products owed to the company by its customers.
They are usually valued using net realizable value (NRV) which is described by the following formula (please note that the formula might vary depending on the asset types as we will demonstrate when discussing inventories):
net realizable value (for accounts receivable) = full value of receivables amount – allowance for doubtful accounts
The allowance that is used to arrive at the net realizable value for the accounts receivable is an estimate of the money that the company expects to be uncollected and will need to be written off in the future.
Analysts focus on the analysis of the accounts receivable as this balance sheet position provides a series of useful information that allows a better understanding of the company’s performance. Let’s deep dive into the major areas of analysis:
Inventories represent the products that the company has produced itself (including the items that are still being produced and relevant raw materials used within the production process) and items that have been bought from suppliers to sell to customers.
Depending on the accounting standards, the valuation methods for the inventories differ. We summarize the methods for the two major accounting regimes – IFRS and U.S. GAAP – in the table below. But first, let’s consider a couple of key definitions:
cost (for inventories) = cost of purchase + cost of conversion + other costs required to bring the inventory to its current condition and location
net realizable value (for inventories) = estimated selling price – costs of completion – costs necessary to complete the sales
|Valuation method||Lower of: cost or net realizable value||Lower of: cost or net realizable value
unless measures using last-in-first-out (LIFO) method or retail inventory method
>> lower of cost or market value
For U.S. GAAP, when the inventory is measured using LIFO or retail inventory method, the inventories need to be measured at the lower of cost or market value
market value under U.S. GAAP (for inventories) = current replacement cost with limits
current replacement cost = lower than NRV and higher than NRV-normal profit margins
Inventory is also subject to impairment testing – when the carrying value of the inventory is higher than the NRV (under IFRS) or market value (under U.S. GAAP), it needs to be adjusted (written off) and the adjustment value should be recorded in the income statement.
The balance sheet position called other current assets gathers information on the assets that are not material enough to be presented separately.
Investors should study notes to the financial statements to better understand what the other current assets position consists of. Within this group, we should expect to see prepaid expenses that represent the company’s spending paid in the current reporting period, even though it refers to the subsequent reporting periods (money paid in advance). This is why they are not expensed through the income statement but capitalized in the form of assets.
Typical events that lead to the recognition of prepaid expenses are purchases of insurance policies, rents, etc.
By analogy with current assets, current liabilities are the ones that the company expects to settle within one year or one business cycle.
Let’s now dive into the most common types of current liabilities that the readers of financial statements can encounter.
Accounts Payable and Financial Liabilities
Accounts payable (called also trade payables) represent the amounts that the company owes to its business partners. Investors and analysts are keen to investigate the accounts payable position, especially the trending of this balance, as it provides a useful insight into the relationship that the company has with its creditors (trade payables are a form of financing that vendors provide to the firm).
Accounts payable, together with other short-term forms of financing such as short-term loans, credit notes, and short-term debt issuance, create a group called financial liabilities.
It is worth noting that financial liabilities will include a short-term portion (due within 1 year) of any long-term (due beyond 1 year) liability.
- Current assets include cash and cash equivalents, marketable securities, accounts receivable, inventories, and other current assets.
- Cash and cash equivalents are the most liquid assets on the balance sheet as they are expected to be used within 3 months from the reporting date. They are valued using amortized cost or the fair value method.
- Marketable securities are financial assets that are traded and whose price can be observed on public markets. They include common stocks, bonds, and mutual funds.
- Trade receivables (or accounts receivable) are financial assets that show how much is being owed to the company by its customers for the goods sold. They are being valued using the net realizable value method which includes an allowance for doubtful accounts.
- Inventories are the physical products that are ready to be sold to customers, products that are still in production, and inputs to the production process.
- Under IFRS, inventories are valued at the lower of cost and net realizable value, while under U.S. GAAP – they are valued at the lower of cost and net realizable value until they are measured using the last-in-first-out method (LIFO).
- Other current assets reflect assets individually immaterial to be presented in the balance sheet as a separate position. They usually include prepaid expenses that the company has paid in advance even though they refer to future periods.
- Current liabilities are liabilities that the firm plans to settle within 12 months or one operating cycle.
- Current liabilities include accounts payable and financial liabilities, accrued expenses, and deferred income.
- Trade payables (aka. accounts payable) are the money that the company owes to its vendors and suppliers and that is connected with the major operating activity and represents a source of financing to the company.
- Financial liabilities include short-term debts, notes, and loans due within 12 months.
- Accrued expenses are the expenses that have been recognized in the current period income statement but not yet paid (e.g., taxes due).
- Deferred income is generated when a company receives the money for the goods and services in advance, while those goods and services will be provided in the subsequent reporting periods (e.g., subscription fees received upfront).