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Chapter 8 - Solution Manual

Since inventory is used in day to day activities it

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Since inventory is used in day-to-day activities it should be included. The inventory must be sold to generate cash flow. If anything we could argue that because inventory is reported at cost, it is actually undervalued, but it would not follow that it should be excluded. Except for a few industries (such as breweries) that have long operating cycles, companies typically turn their inventory many times during the year, continuously providing operating cash inflows to pay currently incurred short term obligations. Paton argued that a fixed asset will remain in the enterprise two or more periods, whereas current assets will be used more rapidly; fixed assets may be charged to expense over many periods, whereas current
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164 assets are used more quickly; and fixed assets are used entirely to furnish a series of similar services, whereas current assets are consumed. Therefore, all assets that meet the definition of current assets, should be included in calculating working capital The working capital concept provides useful information by giving an indication of an entity’s liquidity and the degree of protection given to short-term creditors. Specifically, the presentation of working capital can be said to add to the flow of information to financial statement users by (1) indicating the amount of margin or buffer available to meet current obligations, (2) presenting the flow of current assets and current liabilities from past periods, and (3) presenting information on which to base predictions of future inflows and outflows. In the following sections, we examine the measurement of the items included under working capital. Prepaid expenses have been included as current assets because if they had not been acquired, they would require the use of current assets in the normal operations of the business Team 2 Current U.S. and international practice is based on the assumption that the items classified as current assets are available to retire existing current liabilities and that the measurement procedures used in valuing these items provide a valid indicator of the amount of cash expected to be realized or paid. Closer examination of these assumptions discloses two fallacies: (1) not all the items are measured in terms of their expected cash equivalent, and (2) some of the items will never be received or paid in cash. However, prepaids will be used rather than exchanged for cash and, therefore, do not aid in predicting future cash flows. If the working capital concept is to become truly operational, it would seem necessary to modify it to show the amount of actual buffer between maturing obligations and the resources expected to be used in retiring them. Such a presentation should include only the current cash equivalent of the assets to be used to pay the existing debts. It would therefore seem more reasonable to base the working capital presentation on the monetary–nonmonetary dichotomy used in price level accounting (See Chapter 17.)
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