1. FINANCIAL STATEMENTS II:
CHAPTER 7
FINANCIAL STATEMENTS II:
Balance Sheet
Statement of Cash Flows

2. Statement of Retained Earnings Statement of Cash Flows
Introduction
Financial reports can be divided into two categories
Results of the flows of resources over time (flows)
The status of resources at a point in time (stocks)
Statement of Retained Earnings
Income
Statement
Statement of Cash Flows
Balance Sheet

3. Past Emphasis Income statement
based on the assumption that flows were more important than stocks
Frequently resulted in the measurement of stocks at residual values

4. FASB asset - liability approach
changes in balance sheet amounts becoming more important in income determination

5. Statement of Cash Flows
In this chapter
Balance sheet and the associated measurement techniques for its elements
Statement of cash flows and its evolution over time
Balance Sheet
Statement of Cash Flows

6. The Balance Sheet
Should disclose wealth of a company at a point in time
Wealth is present value of all
resources
obligations

7. The Balance Sheet This measurement technique is limited
Consequently, a variety of measurement techniques are used to measure the elements of the balance sheet
Historical (Historical cost)
Current oriented (Current value)
Future oriented (Expected realizable value)

8. Balance Sheet Elements
The elements of the balance sheet were defined in SFAC No. 6 as:
Assets
Liabilities
Equity
Definitions arise from the FASB’s asset - liability approach to income determination
Departure from previous definitions that resulted in valuations arrived at via the residual effect of income determination

9. Components of the Balance Sheet
Assets
Current assets
Investments
Property, plant, and equipment
Intangible assets
Other assets
Liabilities
Current liabilities
Long-term debt
Other liabilities
Stockholder’s Equity
Capital stock
Additional paid-in capital
Retained earnings

10. Asset Valuation Asset Cash Accounts receivable Marketable securities
Inventory
Investments
Property, plant and equipment
Measurement basis
Current value
Expected future value
Fair value
Current or past value
Fair value or amortized cost
Depreciated past value

11. Liabilities and Their Associated Measurement Techniques
Liability
Current Liabilities
Long-term & Other Liabilities
Measurement
Liquidation Value
Liquidation Value or Present Value
Do measurement techniques bias statements in favor of current investors?

12. Stockholders’ Equity Accounts and Their Associated Measurement Techniques
Common Stock
Preferred Stock
Retained Earnings & Other Comprehensive Income
Measurement basis
Historical Cost (Par Value vs Selling Price)
Historical Cost
Dependent upon income Recognition

13. Fair Value Measurements under SFAS No. 157
New definition for fair value
Hierarchy for sources of information
New disclosures of assets and liabilities
Modification of presumption of transaction price

14. Proposed Statement of Financial Position
FASB-IASB Project (Phase B)
Groups assets and liabilities together
Operating
Investing
Financing
Provides separate section for stockholders’ equity
Assets & Liabilities Operating Investing Financing Stockholders’ Equity

15. Evaluating A Company’s Financial Position
Return on Assets
Net operating profit after taxes
Average total assets
Profit margin
Net sales
Asset utilization rate

16. Hershey & Tootsie Ratios for 2005
Return on assets % %
Profit margin % %
Asset turnover

17. Hershey and Tootsie: Return on Assets

18. Evolution of the Statement of Cash Flows
Prior to 1971
only two required financial statements
Firms were preparing funds statements
No guidelines - Methods of preparing statement:
Cash
Working capital
All financial resources
APB No. 3 - recommended
APB No mandatory - all financial resources

19. APB Opinions 3 and 19 Designed to answer the following questions
Where did the profits go?
Why weren’t dividends larger?
How was it possible to distribute dividends in the presence of a loss?
Why are current assets down when there was a profit?
Why is extra financing required?
How was the expansion financed?
Where did the funds from the sale of securities go?
How was the debt retirement accomplished?
How was the increase in working capital financed?

20. Cash Flow Information Should enable financial statement users to
Predict the amount of cash that is likely to be distributed as dividends or interest
Evaluate risk
Presentation of cash flow information assists in evaluating
Liquidity
nearness to cash
Solvency
going concern
Financial flexibility
react to crisis

21. Historical Perspective
Discussion memorandum
“Reporting Funds Flows, Liquidity, and Financial Flexibility”
preceded the issuance of SFAS No. 95
Questions raised in this DM included:
Which concept of funds should be adopted?
How should transactions not having a direct impact on funds be reported?
Which of the various approaches should be used for presenting funds flow information?
How should information about funds flow from operations be presented?
Should funds flow information be separated into outflows for
maintenance
expansion of operating capacity, and
nonoperating purposes

22. Historical Perspective
Exposure Draft
“Reporting Income, Cash Flows and Financial Position of Business Enterprises”
SFAC No. 5
“Recognition and Measurement in Financial Statements of Business Enterprises”

23. Purpose of the Statement of Cash Flows
Provide relevant information about cash receipts and cash payments of an enterprise
Objectives of accounting discussed in SFAC No’s. 1 and 5 led to conclusion
Statement of cash flows should replace the previously required statement of changes in financial position

24. Statement Format
Report changes during an accounting period in cash and cash equivalents for
Net cash flows from operations
Investing transactions
Financing transactions

25. Cash Flows From Operating Activities
Cash effect from transactions that enter into the determination of net income
exclusive of financing and investing activities
Direct vs Indirect method

26. Cash Flows From Investing Activities
Making and collecting loans
Acquiring and disposing of debt or equity securities of other companies
Acquiring and disposing of property, plant, and equipment and other productive resources

27. Cash Flows From Financing Activities
Results from…
Obtaining resources from owners
Providing owners with a return of and a return on their investment
Borrowing money and repaying the amount borrowed
Obtaining and paying for other resources from long-term creditors

28. Proposed Statement of Cash Flows
Phase B of FASB-IASB Presentation Project
Expanded version of direct method
Additional disclosures for each category

29. Uses of Cash Flow Information
A major objective of accounting
to provide data allowing the presentation of cash flows to investors and creditors
to allow evaluation of risk
Net income is not directly associated with cash
Investors expect return equal to market rate of interest for investments with equal risk
discounted future cash flows > investment

30. Uses of Cash Flow Information
Past cash flows are the best indicators of future cash flows
Empirical research indicates cash flow information
has an incremental value over earnings
and is superior to disclosure of changes in working capital

31. Uses of Cash Flow Information
Net cash provided (used) from operating activities
- Net cash provided (used) from investing activities
Free Cash Flow

32. Uses of Cash Flow Information

33. Uses of Cash Flow Information
These results indicate
Hershey experienced deteriorating free cash flow positions during fiscal year 2005
Tootsie’s position improved

34. International Accounting Standards
The IASC has discussed:
The statement of financial position and the various measurement bases used in accounting
Defined assets, liabilities and equity in “Framework for the Preparation and Presentation of Financial Statements”
The information to be disclosed on the balance sheet and statement of cash flows in a revised IAS No. 1
The presentation of the statement of cash flows in IAS No. 7, “Cash Flow Statements”

35. Preparation and Presentation of Financial Statements
Economic decisions made by users require an evaluation of the ability of an enterprise to generate cash
Financial position of an enterprise is affected by its
financial structure
liquidity and solvency
capacity to adapt to change (financial flexibility)
Measurement bases include
historical cost (most common)
current cost
realizable value
present value
Definitions of assets, liabilities and equity are similar to U. S. GAAP

36. IAS No. 1: Presentation of Financial Statements
Recommends disclosures similar to U. S. GAAP
Revised IAS No. 1
requires assets to be classified as current and noncurrent
unless a liquidity presentation provides more relevant and reliable information
recognizes that there are differences in the nature and function of assets, liabilities, and equity
so fundamental that they should be presented on the face of the balance sheet.
Specifies specific categories of items to be disclosed

37. IAS No. 7
The required presentation of the statement of cash flows is very similar to U. S. GAAP
Operating, financing and investing activities are to be disclosed
Indirect or direct method of disclosing operating activities may be used
stated a preference for the direct method.
FASB staff reaction

38. Prepared by Richard Schroeder, PhD Kathryn Yarbrough, MBA
End of Chapter 7
Prepared by Richard Schroeder, PhD Kathryn Yarbrough, MBA
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