Explain how assets and liabilities should be classified on the balance sheet. What are the problems with this classification method?
What will be an ideal response?
ANSWER:
ARB 43 requires classification of assets and liabilities based on liquidity. Two classifications are used—current and non-current. Current is defined as the firm’s operating cycle or one year, whichever is longer. The operating cycle is the time required to go from materials acquisition to cash collection from revenues.
The current–non-current approach gives only a crude indi-cation of a firm’s liquidity. Current assets cannot be used to assess critical cash flow capacity because the operating cycle may be a year or even longer. In addition, the current asset grouping contains some assets that do not affect cur-rent cash flows at all. A monetary–non-monetary classifi-cation combined with a current-non-current classification would give a better understanding of future cash flows. Another way of subclassifying assets would be according to those held for exchange, those held for use, and those representing deferred charges. This would provide some additional information about how economic benefits will be realized and the uncertainty surrounding realization.
More detailed reporting could also be made of liabilities. Separate classifications by type would assist in evaluating the nature of the different types of obligations and which ones are legally enforceable in the event of bankruptcy.
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