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• W240864806 abstract "EXECUTIVE SUMMARY * A flaw in U.S. GAAP/IFRS financial reporting standards distorts the calculation of capital and the ratio, understating the liquidity of most companies. * Conventional financial reporting places the portion of long-term debt (CPLTD) among liabilities because it is a liability due in the period. That approach, however, incorrectly implies that CPLTD will be repaid from the conversion of assets into cash. * The standard sheet fails to match the CPLTD with the fixed asset that repays it. To truly balance a sheet in terms of what is and what is long term, a new concept is needed-the portion of fixed assets (CPFA). The CPFA is the portion of the fixed asset that will be used up in the period to generate revenue. This year's CPFA is next year's depreciation expense. * The debt service coverage ratio, used in commercial lending, is an effective tool for measuring repayment of long-term loans. It correctly captures the concept that the use of the fixed asset generates revenue that is used to repay the CPLTD. * Two possible approaches could fix the distorted liquidity picture: focusing on the trading cycle by taking CPLTD out of liabilities; or developing a new current ratio that leaves CPLTD with liabilities but calculates CPFA and reports it with assets. The latter approach would require a change in financial reporting standards. ********** A fundamental flaw in U.S. GAAP and IFRS financial reporting standards distorts the calculation of capital and the ratio, resulting in a significant understatement in most companies' liquidity. This outcome is detrimental not only to the companies but also to the economy overall, because it reduces the amount of credit available to businesses. A particularly negative consequence occurs when the flaw results in the reporting of a negative level of capital--one of the stress alarms that auditors use to determine if they should report that a company is in danger of bankruptcy. Consider this common scenario: George has $5,000 to start a business and $200 in his pocket. He wins a lottery for a license to own and operate a taxi. He puts $5,000 down on a $25,000 car and borrows the difference, $20,000, on a five-year loan. His sheet is simple: * One asset = $200 cash. * One fixed asset = the car at full value of $25,000. * One liability = the portion of long-term debt (CPLTD) of $4,000 (one-fifth of the $20,000 loan balance). * One long-term liability = $16,000 (four-fifths of the loan balance). * Equity = $5,200. What is George's working capital? According to conventional thinking, it would be defined as assets ($200 cash) minus liabilities ($4,000 CPLTD) or a negative $3,800. Right from the start of his business, George has a negative level of capital. Moreover, with no inventory and no accounts receivable (since even credit cards clear in a day), George will have a negative capital for the next five years. The common view of this situation based on this method of calculation is that George's business is illiquid and he won't be able to repay his loan. But that's not correct. Conventional accounting reports CPLTD among liabilities because, logically, it is a liability due in the period. However, that approach implies that CPLTD will be repaid from the conversion of assets into cash. [ILLUSTRATION OMITTED] But, in reality, George will repay his loan with the revenue that he takes in using the taxi, which is a fixed asset. Here is the problem: The standard sheet fails to match the CPLTD with the fixed asset that repays it--the taxi. …" @default.
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• W240864806 date "2012-04-01" @default.
• W240864806 modified "2023-09-24" @default.
• W240864806 title "The Missing Piece in Liquidity Calculations: Why Calculating the Current Portion of Fixed Assets Would Provide a More Accurate Picture of Financial Health" @default.
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