CHAPTER 7
FINANCIAL STATEMENTS II:
Introduction
Financial reports can be divided into two
categories
1.
Results of the flows of resources over time (flows)
2.
The status of resources at a point in time (stocks)
Statement
of
Retained
Earnings
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
In this chapter
Balance sheet and the associated measurement
techniques for its elements
Statement of cash flows and its evolution over time
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
Measurement basis
Cash
Current value
Accounts receivable
Expected future value
Marketable securities
Fair value
Inventory
Current or past value
Investments
Fair value or amortized cost
Property, plant and equipment
Depreciated past value
Liabilities and Their Associated
Measurement Techniques
Liability
Measurement
Current Liabilities
Liquidation Value
Long-term &
Other Liabilities
Liquidation Value
or Present Value
Do measurement techniques
bias statements in favor of
current investors?
Stockholders’ Equity Accounts and
Their Associated Measurement
Techniques
Account
Measurement basis
Common Stock
Historical Cost
(Par Value vs Selling Price)
Preferred Stock
Historical Cost
Retained Earnings
& Other
Comprehensive
Income
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
Evaluating A Company’s Financial Position
Return on Assets
Net operating profit after taxes
Average total assets
Profit margin
Net operating profit after taxes
Net sales
Asset utilization rate
Net sales
Average total assets
Hershey & Tootsie Ratios for 2005
Return on assets
Profit margin
Asset turnover
Hershey
15.31%
12.83%
1.19
Tootsie
9.5870%
15.9770%
0.60
Hershey and Tootsie: Return on Assets
Return on Assets
15.62%
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
12.17%
9.51%
8.75%
2004
Hershey
2005
Tootsie
Evolution of the Statement
of Cash Flows
Prior to 1971
Firms were preparing funds
statements
No guidelines - Methods of preparing statement:
1
2
3
only two required
financial statements
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
1
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?
2
3
4
5
6
7
8
9
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
Solvency
nearness to cash
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
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
Free Cash Flow (in millions)
500
400
400.279
300
200
100
0
43.403
2004
Hershey
59.458
52.702
2005
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 accounting
Defined assets, liabilities and equity in “Framework for the
Preparation and Presentation of Financial Statements”
2
3
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
recognizes that there are differences in the nature and function of
assets, liabilities, and equity
unless a liquidity presentation provides more relevant and reliable
information
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
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