CHAPTER 7FINANCIAL STATEMENTS II:

Balance

Sheet

Statement of Cash Flows

Introduction Financial reports can be divided into two

categories1. Results of the flows of resources over time (flows)

Statementof

Retained Earnings

2. The status of resources at a point in time (stocks)

BalanceSheet

Income

Statement

Statementof

Cash Flows

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

FASB asset - liability approach changes in balance sheet amounts becoming

more important in income determination

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

The Balance Sheet

Should disclose wealth of a company at a point in time Wealth is present value of all

resources obligations

The Balance Sheet

This measurement technique is limited Consequently, a variety of measurement techniques are

used to measure the elements of the balance sheetHistorical (Historical cost)

Current oriented (Current value)

Future oriented (Expected realizable value)

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

Components of the Balance Sheet

AssetsCurrent assetsInvestmentsProperty, plant, and equipmentIntangible assetsOther assets

LiabilitiesCurrent liabilitiesLong-term debtOther liabilities

Stockholder’s EquityCapital stockAdditional paid-in capitalRetained earnings

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

Liability

Current Liabilities

Long-term &Other Liabilities

Measurement

Liquidation Value

Liquidation Valueor Present Value

Liabilities and Their Associated Measurement Techniques

Do measurement techniques bias statements in favor of

current investors?

Account

Common Stock

Preferred Stock

Retained Earnings& OtherComprehensiveIncome

Measurement basis

Historical Cost(Par Value vs Selling Price)

Historical Cost

Dependent upon incomeRecognition

Stockholders’ Equity Accounts and Their Associated Measurement Techniques

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

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

OperatingInvestingFinancing

Stockholders’ Equity

Evaluating A Company’s Financial Position

Return on AssetsNet operating profit after taxes

Average total assetsProfit margin

Net operating profit after taxesNet sales

Asset utilization rateNet sales

Average total assets

Hershey & Tootsie Ratios for 2005

Hershey Tootsie

Return on assets 15.31% 9.5870%

Profit margin 12.83% 15.9770%

Asset turnover 1.19 0.60

Hershey and Tootsie: Return on Assets

15.62%

8.75%

12.17%

9.51%

0.00%2.00%4.00%6.00%8.00%

10.00%12.00%14.00%16.00%

2004 2005

Return on Assets

Hershey Tootsie

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:1 Cash2 Working capital3 All financial resources

APB No. 3 - recommended APB No. 19 - mandatory - all financial resources

APB Opinions 3 and 19

Designed to answer the following questions 1 Where did the profits go?2 Why weren’t dividends larger?3 How was it possible to distribute dividends

in the presence of a loss?4 Why are current assets down when there was a profit?5 Why is extra financing required?6 How was the expansion financed?7 Where did the funds from the sale of securities go?8 How was the debt retirement accomplished?9 How was the increase in working capital financed?

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

Historical Perspective

Discussion memorandum “Reporting Funds Flows, Liquidity, and Financial Flexibility” preceded the issuance of SFAS No. 95

Questions raised in this DM included:1. Which concept of funds should be adopted?2. How should transactions not having a direct impact on funds be

reported?3. Which of the various approaches should be used for presenting

funds flow information?4. How should information about funds flow from operations be

presented?5. Should funds flow information be separated into outflows for

(a) maintenance(b) expansion of operating capacity, and(c) nonoperating purposes

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”

Purpose of the Statement of Cash Flows

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

Provide relevant information about cash receipts and cash payments of an enterprise

Statement Format

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

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

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

Cash Flows From Financing Activities

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

Results from…

Proposed Statementof

Cash Flows

Proposed Statement of Cash Flows

Phase B of FASB-IASB Presentation Project Expanded version of direct method Additional disclosures for each category

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 > investmentdiscounted future cash flows > investment

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

Uses of Cash Flow Information

Net cash provided (used) from operating activities

- Net cash provided (used) from investing activities

Free Cash Flow

Uses of Cash Flow InformationFr ee Cash Fl ow (in mil l ions)

43.403 52.70259.458

400.279

0

100

200

300

400

500

2004 2005

Her shey Tootsie

Uses of Cash Flow Information

These results indicate Hershey experienced

deteriorating free cash flow positions during fiscal year 2005

Tootsie’s position improved

International Accounting Standards

The IASC has discussed:1 The statement of financial position

and the various measurement bases used in accountingDefined assets, liabilities and equity in “Framework for the Preparation and Presentation of Financial Statements”

2 The information to be disclosed on the balance sheet and statement of cash flows in a revised IAS No. 1

3 The presentation of the statement of cash flows in IAS No. 7, “Cash Flow Statements”

Preparation and Presentation of Financial Statements

Economic decisions made by users require an evaluation of the ability of an enterprise to generate cashFinancial 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

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

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

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Prepared by Richard Schroeder, PhDKathryn Yarbrough, MBA