Prepared by: Gabriela H. Schneider, CMA; Grant MacEwan College INTERMEDIATE ACCOUNTING INTERMEDIATE ACCOUNTING Sixth Canadian Edition KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK

C H A P T E R 5 Financial Position and Cash Flows

Learning Objectives 1.Identify the uses and limitations of a balance sheet. 2.Identify the major classifications of the balance sheet. 3.Prepare a classified balance sheet. 4.Identify balance sheet information requiring supplemental disclosure.

Learning Objectives 5.Identify major disclosure techniques for the balance sheet. 6.Indicate the purpose of the statement of cash flows. 7.Identify the content of the statement of cash flows. 8.Prepare a statement of cash flows. 9.Understand the usefulness of the statement of cash flows.

Balance Sheet and Statement of Cash Flows Balance Sheet Usefulness Limitations Classification Format Additional information Techniques of disclosure Terminology Statement of Cash Flows Purpose Content and Format Preparation Usefulness

Balance Sheet: Usefulness The balance sheet provides information: –for evaluating the capital structure –for computing rates of return It is also useful for analysing an enterprise’s: –liquidity (ability to pay current and maturing debt) –solvency (ability to pay debt, and interest, as it matures) –financial flexibility (ability to respond to unexpected needs and opportunities)

Balance Sheet: Limitations 1 Most assets and liabilities are stated at historical cost. – information presented is reliable, however – reporting at current fair value may result in more relevant information 2 Judgements and estimates are used in determining many of the items reported. – “soft” numbers (estimates) less reliable than “hard” numbers 3 The balance sheet does not report items that can not be objectively determined (e.g. The ‘value’ of experienced staff).

Balance Sheet Classification Similar items are grouped together, with sub-total Individual balance sheet items should be reported separately, and in sufficient detail in order to –allow users to assess amounts, timing and uncertainty of future cash flows –allow users to evaluate:  liquidity  financial flexibility  profitability  risk

Balance Sheet Classification Guidelines for reporting items separately: 1) Assets that differ in their type or expected function in the central operations 2) Assets and liabilities that have different implications for the enterprise’s financial flexibility 3) Assets and liabilities with different general liquidity characteristics

Balance Sheet: Classification Current Assets Long-term investments Property, plant, and equipment Intangible assets Other assets Current liabilities Long-term debt Owners’ equity –Capital stock –Additional paid-in capital –Retained earnings AssetsLiabilities and Equity

Current Assets Current assets are expected to be consumed, sold, or converted into cash: – either in one year or – in the normal operating cycle, whichever is longer. They are presented in order of liquidity The following valuation principles are used: – short-term investments at fair value – accounts receivable at net realizable value

The Business Operating Cycle for Manufacturing Purchase Raw Materials Cash Manufacture Product Sell Product to Customers

Five major items comprise Current Assets ­Cash ­Short-term investments ­Receivables ­Inventories ­Prepayments (Prepaid Expenses) Current Assets

Current Assets - Cash Includes cash and cash equivalents Defined as: –cash –demand deposits –short-term, liquid investments readily convertible to a known cash amount, and not subject to material value changes Any known restrictions to cash must be disclosed

Current Assets - Receivables Amounts should be reported separately based on the nature of their origin: –ordinary trade accounts –amounts owing by related parties –other (material) unusual items Separate disclosure required for: –anticipated losses (uncollectibles) –amount and nature of non-trade receivables –receivables pledged as collateral

Current Assets - Inventories Valuation basis (lower of cost or market) disclosed Method of pricing (FIFO or LIFO) disclosed Manufacturing enterprise will disclose completion stage of inventories –raw materials –work in progress –finished goods

Current Assets – Prepaid Expenses Defined as: expenditures already made for benefits to be received within one year or within the operating cycle Most common examples include –insurance –rent –advertising –supplies Current practice is to report some prepaid amounts where the benefit extends beyond one year (or operating cycle)

Long-Term Investments Four common types of Long-Term Investments: – investments in securities – investments in tangible fixed assets not used in current operations – investments set aside in special funds for specific purposes – investments in non-consolidated subsidiaries or affiliated companies The intent of these investments is that they are: - held for an extended period of time - reported at cost or amortized cost - only adjusted to current value if there is a non- temporary decline in value

Property, Plant and Equipment Physical (tangible) assets used in the regular operations of the business to generate revenue Disclosure requirements include: –basis of valuation –nature of any liens held against the asset –accumulated amortization

Intangible Assets Those assets without physical substance, held to generate revenue High degree of uncertainty regarding future benefits Subject to arbitrary write-downs or write-offs due to valuation/measurement difficulties Include (most common): –Patents –Copyrights –Franchises –Goodwill –Trademarks, and trade names

Current Liabilities Current liabilities are liquidated: – either through the use of current assets, or – by creation of other current liabilities Examples of current liabilities include: – payables resulting from acquisitions of goods and services – collections received in advance of services – other liabilities which will be paid in the short term

Working Capital Current Assets - Current Liabilities = Working Capital A key indicator of the company’s short- term liquidity Not usually disclosed on the balance sheet Often calculated by creditors

Long-term Liabilities Long-term obligations are those not expected to be paid within the operating cycle Examples are: – obligations arising from specific financing situations – obligations arising from ordinary business operations –obligations that are contingent –Balance sheet presentation requires reporting that portion due within the next year as a current liability

Owners’ Equity Capital Shares: –Number of authorized and issued shares –Outstanding amounts Contributed Surplus: –Usually reported as one amount Retained Earnings: –Divided between un-appropriated and restricted amounts –Reacquired (Treasury) shares reported as a reduction of equity

Balance Sheet: Additional Information Reported Additional information may be: -information not presented elsewhere, or -information that qualifies items in the balance sheet Five main types of additional information: 1.Contingencies 2.Accounting policies 3.Contractual situations 4.Additional detail 5.Subsequent events

Balance Sheet: Techniques of Disclosure 1 Parenthetical explanations (following the items in the balance sheet) 2 Notes (to the balance sheet) 3 Cross references and contra items (where assets and liabilities may be cross-referenced) 4 Supporting schedules (as for fixed assets depreciation)

Statement of Cash Flows Assesses the firm’s ability to generate cash and cash equivalents Assesses the firm’s cash requirements or uses Statement of Cash Flows shows –Where did the cash come from? –What was the cash used for? –What was the change in the cash balance?

Statement of Cash Flows Cash activities are divided into three main categories: Operating Activities –Normal day-to-day activities Investing Activities –Changes in long-term assets and investments Financing Activities –Changes in equity and non-operating liabilities

Statement of Cash Flows There are TWO methods of preparing the statement of cash flows: –direct method (alternative #1) –indirect method (alternative #2) The direct method analyses balance sheet account changes The indirect method analyses the changes in cash by determining cash flows directly for each source or use of cash Any non-cash transactions are omitted from the statement (under each method)

Cash Inflows and Outflows Operating Activities When operating cash receipts > cash expenditures Cash Pool Investing Activities Sale of property, plant and equipment Sale of debt or equity securities of other entities Collection of loans to other entities Financing Activities Issuance of equity securities Issuance of debt (bonds and notes) Cash Inflows

Cash Inflows and Outflows Cash Pool Investing Activities Purchase of property, plant and equipment Purchase of debt or equity securities of other entities Loans to other entities Operating Activities When operating cash expenditures < cash receipts Financing Activities Payment of dividends Redemption of debt Reacquisition of capital stock Cash Outflows

Preparing a Cash Flow Statement Alternative #1 (Direct Method) Information required: 1.Comparative Balance Sheets 2.Current Income Statement 3.Other information and transaction data

Direct Method Operating Activities Start with Net Income (Loss) Changes in Current Assets (other than cash) and Liabilities –Increase in a current asset = use of funds (Decrease = source of funds) –Increase in a current liabilities = source of funds (Decrease = use of funds) Non-cash expenses (e.g. amortization, bad debts expense) Non-operating gains and losses –Gains are treated as a use of funds from operating activities –Losses are treated as a source of funds from operating activities

Direct Method Investing Activities Changes in Long-term assets –Increase = use of funds –Decrease = source of funds If assets have been disposed, report only the cash proceeds of disposition Financing Activities Changes in Long-term liabilities and equity –Increase = source of funds –Decrease = use of funds

Usefulness of the Statement of Cash Flows Cash is the long-term indicator of a firm’s success or failure Useful to creditors in answering three main questions 1.Success in generating net cash from operating activities 2.Operating cash flow trends or patterns 3.Major reasons for positive or negative net cash from operating activities

Usefulness of the Statement of Cash Flows Provides insight within the following areas:  Financial Liquidity Current Cash Debit Coverage Ratio = Net Cash Provided by Operating Activities Average Current Liabilities  Financial Flexibility Cash Debt Coverage Ratio = Net Cash Provided by Operating Activities Average Total Liabilities

Usefulness of the Statement of Cash Flows  Cash Flow Patterns Is the firm getting the biggest “bang” for its buck?  Free Cash Flow Net cash from operations less capital expenditures and dividends Indicates discretionary cash flow (cash left to invest or expand)

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