Chapter 8 - Solution Manual

Case 8 10 ai short term prepaids are classified as

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Case 8-10 a.i. Short-term prepaids are classified as current assets because they will be consumed during the current operating cycle or one year whichever is longer. These assets will not be converted into cash. Rather, they would require the use of cash in the near future had cash not already been expended. Prepaids meet the definition of assets found in the conceptual framework because they will provide future benefit. For example, prepaid rent is an asset. The right to use an asset, say office space, was paid for in advance. That payment provides future benefit: the use of the asset over some future time period. Prepaids do not provide working capital in the usual sense of the definition of working capital. Working capital is a measure of the ability of the firm to pay currently maturing debt. Since prepaids will not generate cash, they will not be used to pay debt. However, it may be argued that they indirectly provide liquidity because the services which have already been paid for are needed for operations. If they had not already been paid for, they would require the use of cash which would decrease the firm’s ability to pay current debt. ii. The most convincing argument for excluding prepaids from working capital is that they will not provide cash to pay currently maturing debt. They have no net realizable value. If not, it is difficult to say that prepaids provide liquidity. b. Accountants include short-term unearned revenues as current liabilities because they will be earned by performing services during the current operating cycle or year whichever is longer. The conceptual framework defines liabilities as probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to
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152 other entities in the future as the result of prior transactions or events. Yes, unearned revenues meet the definition of liabilities. They are present obligations to provide services to other entities in the future as a result of prior transactions or events (the receipt of cash from an arm’s length transaction). Since they are classified as current liabilities, current unearned revenues decrease working capital. However, they will not require the expenditure of current assets. c. Current liabilities are defined as liabilities that will be paid out of current assets or replaced by other current liabilities. Current unearned revenues will not be paid with cash or any other assets. Moreover, they will not be replaced by other current liabilities. And if the purpose of classification of liabilities as current is to provide measures of liquidity, it is difficult to see how a liability that will not be paid affects liquidity. FASB ASC 8-1 Current Assets and Current Liabilities Information on the disclosure of current assets and current liabilities is found at FASB ASC 210. It can be accessed through the presentation line or searching “current assets and current liabilities.” The students summaries should contain the following:
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