Structure of the

Balance Sheet and

Statement of Cash Flows

Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 4
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution
without the prior written consent of McGraw-Hill Education
 Learning Objectives
After studying this chapter, you will understand:

1. How the various asset, liability, and stockholders’ equity accounts

on a typical corporate balance sheet are measured and classified.
2. How to use balance sheet information to understand key
differences in the nature of firms’ operations and how those
operations are financed.
3. The information provided in notes to the financial statements on
significant accounting policies, subsequent events, and related-
party transactions.
4. How successive balance sheets and the income statement can
be used to determine cash inflows and outflows for a period.

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 Learning Objectives, continued
After studying this chapter, you will understand:

6. How information provided in the cash flow statement can be

used to explain changes in noncash accounts on the balance
sheet.
7. The distinction between operating, investing, and financing
sources and uses of cash.
8. How changes in current asset and current liability accounts can
be used to adjust accrual earnings to obtain cash flows from
operations.

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 Balance Sheet
ASSETS = LIABILITIES
 Current assets  Current liabilities
Cash and other assets Liabilities expected
expected to be to be settled within
converted to cash 12 months (or with
within 12 months (or the operating cycle,
with the operating if longer)
cycle, if longer)  Noncurrent or
 Noncurrent assets Long-term
All other assets liabilities
All other liabilities
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+ EQUITY
 Common stock
The par value of shares
issued and outstanding
 Additional paid-in capital
The amount in excess of
par value paid to the firm
when its shares were
originally issued
 Retained earnings
The cumulative earnings
less cumulative dividend
distributions of the
company since its
inception.
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 Balance Sheet

Historical cost

ASSETS Current replacement cost

Measurement
Net realizable value
LIABILITIES Bases
+ Discounted present value
EQUITY
Discounted present value

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 Balance Sheet Classification:
Current Assets

Net
realizable
value

Lower of cost
or net
realizable
value

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 Balance Sheet Classification:
Other Assets

Historical cost minus accumulated depreciation

(except that fair market value, if lower, is used
when “impaired”)

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 Balance Sheet Classification:
Liabilities

Amount
due at
maturity

Historical
cost
Discounted
present
value of the
future cash
flows

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 Balance Sheet Classification:
Stockholders’ Equity

Historical
par value

Historical
cost

Combinations
of different
measurement
bases

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 Analytical Insights: Understanding
the Nature of a Firm’s Business

Common-Size Balance Sheet

• Presents each item as a percentage of total assets.
• Allows an analysts to compare companies in a way that
factors out differences between balance sheet amounts
due solely to differences in company size.
• The numbers and percentages tell a story about the
company, its industry, its strategies, and its performance.

Copyright © 2018 by McGraw-Hill Education.

 International Differences in
Balance Sheet Presentation
U.S. Format IFRS Format
(U.K. used as an example)
Assets listed from most to least liquid Allows ordering from least to most liquid

Current Assets Noncurrent Assets

+ +
Long-lived Assets Current Assets
-
=
Non-current Liabilities
Current Liabilities -
+ Current Liabilities
Non-current Liabilities
+ =
Stockholders’ Equity Total Equity

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 Statement of Cash Flows

• Because cash flows and accrual earnings can differ

dramatically, firms must present a statement of cash
flows in addition to an income statement and a balance
sheet.
• The cash flow statement explains the causes for year-to-
year changes in cash and cash equivalents.

Copyright © 2018 by McGraw-Hill Education.

 •financing
•interest activities received
and dividends are activities
and that
paidalter
may the equity capital
be classified and borrowing
as operating, structure
investing, of the entity
or financing cash[IAS 7.6]
flows, provided
•financing activities are activities that alter the equity capital and borrowing structure of the entity
•interest and dividends received and paid may be classified as operating, investing, or financing cash flows, [IAS 7.6]
provide
•financing
•interest activities received
and dividends are activities
and that
paidalter
may the equity capital
be classified and borrowing
as operating, structure
investing, of the entity
or financing cash[IAS 7.6]
flows, provid
•interest and dividends received and paid may be classified as operating, investing, or financing cash flows, pro

Structure of Cash Flow Statement

Cash Flow from Comprises the increase or decrease in cash arising

Operating Activities from the firm’s profit-making activities

Comprises the decreases in cash resulting from

Cash Flow from investments made in productive assets or securities
Investing Activities during the period, as well as the increases in cash
when such investments are liquidated

Comprises changes in cash due to transactions

Cash Flow from related to the financing of the business, such as the
Financing Activities issuance or repurchase of debt or equity securities
and the payment of dividends*

Δ (change in) Cash The amount by which cash and cash equivalents
and Cash Equivalents changed from one balance sheet date to the next

* Although interest payments actually are due to financing activities, U.S. GAAP includes
interest payments in operating cash flows.

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 Cash Flows from Operating Activities

There are two methods for presenting cash flow from operating
activities:
The operating section of the cash flow statement
Direct Method presents cash transactions related to the determination
of net income.

The operating section begins with net income and then

Indirect Method presents all the reasons why and amounts by which cash
flow from operations differs from net income.

The resulting amount for cash flow from operating activities is the same under the two
methods.

Both U.S. GAAP and IFRS encourage, but do not require, the use of the direct
method.

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 Example of Indirect Method
Cash Flow Statement

Adjustments to convert accrual-basis earnings to cash-basis earnings

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 Example of Indirect Method
Cash Flow Statement – cont.

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 Example of Direct Method
Cash Flow Statement:
Operating Activities Section

Actual cash inflows and cash outflows

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 Example of Direct Method
Cash Flow Statement:
Investing and Financing Activities
Sections

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 Example of Direct Method
Cash Flow Statement:
Change in Cash and Cash
Equivalents

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 Example of Direct Method
Cash Flow Statement:
Additional Required Disclosures

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 Cash Flow Statement and
Financial Statement
Articulation
 A complete statement of cash flows explains the changes in every
balance sheet account during the period, not just cash.
 Algebraically, the balance sheet equation is used as follows:
Assets = Liabilities + Stockholders’ equity

Cash + Non-cash assets = Liabilities + Stockholders’ equity

Cash = Liabilities - Non-cash assets + Stockholder’s equity

ΔCash = Δ Liabilities - Δ Non-cash assets + Δ Stockholders’ equity

 As such, every line item of a cash flow statement relates to a change in one or
more balance sheet accounts other than cash. Analyzing why each account
changed provides each component of the cash flow statement

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 Deriving Cash Flow Information

Income
statement

Beginning Ending
Balance sheet Balance sheet

Cash flow
statement

You can always derive any one financial statement from

information available in the other three statements.

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 Deriving Cash Flows from Operations:
Indirect approach

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 Notes to Financial Statements

 Notes are an integral part of companies’ financial reports.

 Allow financial statement users to more thoroughly understand and
interpret the numbers presented in the body of the financial
statements.
 Three important notes that are typically found in companies’
financial reports:
1. Summary of significant accounting policies
2. Disclosure of important subsequent events
3. Related-party transactions

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 Subsequent Events

 Events or transactions that have a significant effect on a

company’s financial position or results of operations sometimes
occur after the close of its fiscal year-end but before the
financial statements are issued.
 Disclosure of these subsequent events is required if they are
material and are likely to influence investors’ appraisal of the
risk and return prospects of the reporting entity.
 Examples include:
 Loss of a major customer
 A business combination
 Issuance of debt or equity securities
 A catastrophic loss

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 Summary

 The balance sheet and statement of cash flows are two of the primary
financial statements required under GAAP.
 The balance sheet shows the assets owned by a company at a given
point in time and how those assets are financed (debt versus equity). A
variety of measurement bases are used to report the various asset,
liability, and stockholders’ equity accounts.
 When making intercompany comparisons, financial statement users
must be careful to recognize how the different measurement bases
affect key financial ratios and how account titles and statement formats
vary across countries.
 The statement of cash flows shows the change in cash for a given
period broken down into operating, investing, and financing activities.

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 Summary – cont.

 Successive balance sheets and the statement of cash flows articulate

with one another meaning changes in noncash balance sheet
accounts can be used to explain changes in cash for a period.
 Analysis of changes in selected balance sheet accounts also can be
used to explain why operating cash flows differ from accrual income.
 Conversely, the statement of cash flows provides information that
enables users to understand changes in balance sheet accounts that
have occurred over the reporting period.
 Understanding the interrelationships between successive balance
sheets and the statement of cash flows and being able to exploit these
interrelationships to derive unknown account balances are important
skills for analysts and lending officers.

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 Workshop Discussion

Week 5 Workshop Questions

 Revsine Textbook Chapter 4
 Exercises: E4-3; E4-8; E4-10
 Problems: P4-2; P4-11