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

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

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

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

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 sheet Historical (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 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

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

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?

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

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 Operating Investing Financing Stockholders’ Equity

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

Hershey & Tootsie Ratios for 2005 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

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. 19 - mandatory - all financial resources

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?

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: 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

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 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

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 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

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 > 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 Information

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: 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”

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

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

Prepared by Richard Schroeder, PhD Kathryn Yarbrough, MBA End of Chapter 7 Prepared by Richard Schroeder, PhD Kathryn Yarbrough, MBA Copyright © 2009 John Wiley & Sons, Inc.  All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful.  Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc.  The purchaser may make back-up copies for his/her own use only and not for distribution or resale.  The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.