CHAPTER FOUR

FINANCIAL STATEMENTS AND ADDITIONAL DISCLOSURE

INTRODUCTION
4.4 STATEMENT OF FINANCIAL POSITION

The statement of financial position also referred to as the balance sheet, reports the assets,
liabilities, and equity of a business enterprise at a specific date. This financial statement provides
information about the nature and amounts of investments in enterprise resources, obligations to
creditors, and the equity in net resources. It therefore helps in predicting the amounts, timing, and
uncertainty of future cash flows.

Usefulness of the Statement of Financial Position

By providing information on assets, liabilities, and equity, the statement of financial position
provides a basis for computing rates of return and evaluating the capital structure of the enterprise.
Analysts also use information in the statement of financial position to assess a company’s risk and
future cash flows. In this regard, analysts use the statement of financial position to assess a company’s
liquidity, solvency, and financial flexibility.
 Liquidity describes “the amount of time that is expected to elapse until an asset is realized
or otherwise converted into cash or until a liability has to be paid. ”Creditors are interested
in short-term liquidity ratios, such as the ratio of cash (or near cash) to short-term liabilities.
These ratios indicate whether accompany will have the sources to pay its current and
maturing obligations. Similarly, shareholders assess liquidity to evaluate the possibility of
future cash dividends or the buyback of shares. In general, the greater liquidity, the lower
its risk of failure.
 Solvency refers to the ability of accompany to pay its debts as they mature. For example,
when a company carries a high level of long-term debt relative to assets, it has lower
solvency than a similar company with a low level of long-term debt. Companies with higher
debt are relatively more risky because they will need more of their assets to meet their fixed
obligations (interest and principal payments).
 Liquidity and solvency affect a company’s financial flexibility, which measures the ability
of a company to take effective actions to alter the amounts and timing of cash flows so it can
respond to unexpected needs and opportunities. For example, a company may become so
loaded with debt—so financially inflexible—that it has little or no sources of cash to finance
expansion or to pay off maturing debt. A company with a high degree of financial flexibility is
better able to survive bad times, to recover from unexpected setbacks, and to take advantage
of profitable and unexpected investment opportunities. Generally, the greater an
enterprise’s financial flexibility, the lower its risk of failure.

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 Limitations of the Statement of Financial Position
Some of the major limitations of the statement of financial position are:
 Most assets and liabilities are reported at historical cost. As a result, the information
provided in the statement of financial position is often criticized for not reporting a more
relevant fair value.
 Companies use judgments and estimates to determine many of the items reported in the
statement of financial position.
 The statement of financial position necessarily omits many items that are of financial value
but that a company cannot record objectively. For example, the knowledge and skill of Intel
(USA) employees in developing new computer chips are arguably the company’s most
significant asset. However, because Intel cannot reliably measure the value of its employees
and other intangible assets (such as customer base, research superiority, and reputation), it
does not recognize these items in the statement of financial position. Similarly, many
liabilities are reported in an “off-balance-sheet” manner, if at all.
4.4.1 Classification in the Statement of Financial Position

Statement of financial position accounts are classified. That is ,a statement of financial position
groups together similar items to arrive at significant subtotals. Furthermore, the material is
arranged so that important relationships are shown.
The IASB indicates that the parts and subsections of financial statements are more informative than
the whole. Therefore, the IASB discourages the reporting of summary accounts alone (total assets,
net assets, total liabilities, etc.). Instead, companies should report and classify individual items in
sufficient detail to permit users to assess the amounts, timing, and uncertainty of future cash flows.
Such classification also makes it easier for users to evaluate the company’s liquidity and financial
flexibility, profitability, and risk. To classify items in financial statements, companies group those
items with similar characteristics and separate items with different characteristics. For example,
companies should report separately:
1. Assets and liabilities with different general liquidity characteristics.
2. Assets that differ in their expected function in the company’s central operations or
other activities
3. Liabilities that differ in their amounts, nature, and timing.
The three general classes of items included in the statement of financial position are assets,
liabilities, and equity.

1. ASSET. Resource controlled by the entity as a result of past events and from which
future economic benefits are expected to flow to the entity.
2.LIABILITY. Present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of resources embodying
economic benefits.
3. EQUITY. Residual interest in the assets of the entity after deducting all its liabilities.

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 Companies then further divide these items in to several sub classifications.
Illustration below indicates the general format of statement of financial position presentation.

Assets Equity and Liabilities

Non-current assets Non-current liabilities
Investments Current liabilities
Property, plant, and equipment Equity
Intangible assets Share capital
Other assets Share premium
Current assets Retained earnings
Accumulated other comprehensive income
Non-controlling interest (Minority interest)

Non-Current Assets
Current assets are cash and other assets a company expects to convert to cash, sell, or consume
either in one year or the operating cycle, whichever is longer. Non-current assets are those not
meeting the definition of current assets. They include a variety of items, as we discuss in the
following sections.
Long-Term Investments. Long-term investments often referred to simply as investments, normally
consist of one of four types:
 Investments in securities, such as bonds, ordinary shares, or long-term notes.
 Investments intangible assets not currently used in operations, such
as land held for speculation.
 Investments set aside in special funds, such as a sinking fund, pension
fund, or plant expansion fund.
 Investments in non-consolidated subsidiaries or associated companies.
Companies group investments in debt and equity securities in to three separate portfolios for
valuation and reporting purposes:
•Held-for-collection: Debt securities that a company manages to collect contractual principal
and interest payments.
•Trading (also referred to as designated at fair value through profit or loss):
Debt and equity securities bought and held primarily for sale in the near term to generate
income on short-term price changes.
•Non-trading equity: Certain equity securities held for purposes other than trading
(e.g., to meet a legal or contractual requirement)
A company should report trading securities (whether debt or equity) as current assets. It classifies
individual held-for-collection and non-trading equity securities as current or non-current,

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depending on the circumstances. It should report held-for- collection securities at amortized cost. All
trading and non-trading equity securities are reported at fair value.

Property, Plant, and Equipment. Property, plant, and equipment are tangible long-lived assets used
in the regular operations of the business. These assets consist of physical property such as land,
buildings, machinery, furniture, tools, and wasting resources (minerals). With the exception of land,
accompany either depreciates (e.g., buildings) or depletes (e.g., oiler serves) these assets. A company
discloses the basis it uses to value property, plant, and equipment; any liens against the properties;
and accumulated depreciation—usually in the notes to the statements.

Intangible Assets. Intangible assets lack physical substance and are not financial instruments.
They include patents, copyrights, franchises, goodwill, trademarks, trade names, and customer
lists. A company writes off (amortizes) limited-life intangible assets over their useful lives. It
periodically assesses indefinite-life intangibles (such as goodwill) for impairment. Intangibles can
represent significant economic resources, yet financial analysts often ignore them, because valuation
is difficult. Research and development costs are expensed as incurred except for certain
development costs, which are capitalized when it is probable that a development project will
generate future economic benefits.

Other Assets. The items included in the section “Other assets” vary widely in practice. Some include
items such as long-term prepaid expenses and non-current receivables. Other items that might be
included are assets in special funds, property held for sale, and restricted cash or securities. A
company should limit this section to include only unusual items sufficiently different from assets
included in specific categories.

Current Assets
As indicated earlier, current assets are cash and other assets a company expects to convert into cash,
sell, or consume either in one year or in the operating cycle, whichever is longer. The operating cycle
is the average time between when a company acquires materials and supplies and when it receives
cash for sales of the product (for which it acquired the materials and supplies). The cycle operates
from cash through inventory, production, receivables, and back to cash. When several operating
cycles occur within one year (which is generally the case for service companies), a company uses the
one- year period. If the operating cycle is more than one year, a company uses the longer period.
The five major items found in the current assets section, and their bases of valuation, are shown in
below. These assets are generally presented in the following order.

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Company does not report these five items as current assets if it does not expect to realize them in
one year or in the operating cycle, whichever is longer. For example, accompany excludes from the
current assets section cash restricted for purposes other than payment of current obligations or for
use in current operations. Generally, if a company expects to convert an asset in to cash or to
use it to pay a current liability within a year or the operating cycle, whichever is longer, it
classifies the asset as current.
This rule, however, is subject to interpretation. A company classifies an investment in non-trading
equity securities as either a current asset or anon-current asset, depending on management’s intent.
When it has holdings of ordinary or preference shares or bonds that it will hold long-term, it should
not classify them as current.
Although a current asset is well defined, certain theoretical problems also develop. For example,
how is inclusion of prepaid expenses in the current assets section justified? The rationale is that if a
company did not pay these items in advance, it would instead need to use other cur rent assets
during the operating cycle. If we follow this logic to its ultimate conclusion, however, any asset
previously purchased saves the use of current assets during the operating cycle and would be
considered current.
Another problem occurs in the current-asset definition when accompany consumes plant assets
during the operating cycle. Conceptually, it seems that accompany should place in the current assets
section an amount equal to the current depreciation charge on the plant assets, because it will
consume them in the next operating cycle. However, this conceptual problem is ignored.
This example illustrates that the formal distinction made between some current and non-current
assets is somewhat arbitrary.
Inventories. To present inventories properly, accompany discloses the basis of valuation (e.g.,
lower-of-cost-or-net realizable value) and the cost flow assumption.
Receivables. A company should clearly identify any anticipated loss due to uncollectibles, the
amount and nature of any non-trade receivables, and any receivables used as collateral. Major
categories of receivables should be shown in the statement of financial position or the related notes.
For receivables arising from unusual transactions (such as sale of property, or a loan to associates or
employees), companies should separately classify these as long-term, unless collection is expected
within one year.
Prepaid Expenses. A company includes prepaid expenses in current assets if it will receive benefits
(usually services) within one year or the operating cycle, whichever is longer. As we discussed
earlier, these items are current assets because if they had not already been paid, they would require
the use of cash during the next year or the operating cycle. A company reports prepaid expenses at
the amount of the unexpired or unconsumed cost.
A common example is the prepayment for an insurance policy. A company classifies it as a prepaid
expense because the payment precedes the receipt of the benefit of coverage. Other common
prepaid expenses include prepaid rent, advertising, taxes, and office or operating supplies
Short-Term Investments. As indicated earlier, a company should report trading securities (whether
debt or equity) as current assets. It classifies individual non-trading investments as current or non-
current, depending on the circumstances. It should report held-for-collection (sometimes referred to
as held-to-maturity) securities at amortized cost. All trading securities are reported at fair value.

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Cash. Cash is generally considered to consist of currency and demand deposits (monies available
on demand at a financial institution). Cash equivalents are short- term, highly liquid investments
that will mature within three months or less. Most companies use the caption “Cash and cash
equivalents,” and they indicate that this amount approximates fair value
A company must disclose any restrictions or commitments related to the availability of cash. If
accompany restricts cash for purposes other than current obligations, it excludes the cash from
current assets
Equity The equity (also referred to as shareholders’ equity) section is one of the most
difficult sections to prepare and understand. This is due to the complexity of ordinary and
preference share agreements and the various restrictions on equity imposed by corporation laws,
liability agreements, and boards of directors. Companies usually divide the section into six parts:

For ordinary shares, companies must disclose the par value and the authorized, issued, and
outstanding share amounts. The same holds true for preference shares. A company usually presents
the share premium (for both ordinary and preference shares) in one amount although subtotals are
informative if the sources of additional capital are varied and material. The retained earnings
amount may be divided between the un appropriated (the amount that is usually available for
dividend distribution) and restricted (e.g., by bond indentures or other loan agreements) amounts.
In addition, companies show any shares reacquired (treasury shares) as a reduction of equity.

Accumulated other comprehensive income (sometimes referred to as reserves or other reserves)

includes such items as unrealized gains and losses on non-trading equity securities and unrealized
gains and losses on certain derivative transactions. Non- controlling interest, sometimes referred to
as minority interest, is also shown as a separate item (where applicable) as a part of equity.
The equity accounts in a corporation differ considerably from those in a partnership or
proprietorship. Partners show separately their permanent capital accounts and the balance in their
temporary accounts (drawing accounts). Proprietorships ordinarily use a single capital account that
handles all of the owner’s equity transactions.

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Non-Current Liabilities
Non-current liabilities are obligations that a company does not reasonably expect to liquidate within
the longer of one year or the normal operating cycle. Instead, it expects to pay them at some date
beyond that time. The most common examples are bonds payable, notes payable, some deferred
income tax amounts, lease obligations, and pension obligations. Companies classify non-current
liabilities that mature within the current operating cycle or one year as current liabilities if payment
of the obligation requires the use of current assets.
Generally, non-current liabilities are of three types:
 Obligations arising from specific financing situations, such as the issuance of bonds, long-
term lease obligations, and long-term notes payable.
 Obligations arising from the ordinary operations of the company, such as pension obligations
and deferred income tax liabilities.
 Obligations that depend on the occurrence or non-occurrence of one or more future events to
confirm the amount payable, or the payee, or the date payable, such as service or product
warranties, environmental liabilities, and restructurings, often referred to as provisions.

Companies generally provide a great deal of supplementary disclosure for non- current liabilities
because most long-term debt is subject to various covenants and restrictions for the protection of
lenders.
Companies frequently describe the terms of all non-current liability agreements (including maturity
date or dates, rates of interest, nature of obligation, and any security pledged to support the debt) in
notes to the financial statements
Current Liabilities
Current liabilities are the obligations that a company generally expects to settle in its normal
operating cycle or one year, whichever is longer. This concept includes:
1. Payables resulting from the acquisition of goods and services: accounts payable, salaries
and wages payable, income taxes payable, and soon.
2. Collections received in advance for the delivery of goods or performance of services, such
as unearned rent revenue or unearned subscriptions revenue.
3. Other liabilities whose liquidation will take place within the operating cycle or one year,
such as the portion of long-term bonds to be paid in the current period, short- term
obligations arising from purchase of equipment, or estimated liabilities, such as a warranty
liability. As indicated earlier, estimated liabilities are often referred to as provisions.
At times, a liability that is payable within the next year is not included in the current liabilities
section. This occurs when the company refinances the debt on along- term basis before the end of
the reporting period. This approach is used because liquidation does not result from the use of
current assets or the creation of other current liabilities.
Companies do not report current liabilities in any consistent order. In general, though, companies
most commonly list notes payable, accounts payable, or short- term debt as the first item. Income
tax payables or other current liabilities are commonly listed last Current liabilities include such
items as trade and non-trade notes and accounts payable, advances received from customers, and
current maturities of long-term debt. If the amounts are material, companies classify income taxes

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and other accrued items separately. A company should fully describe in the notes any information
about a secured liability—for example, shares held as collateral on notes payable—to identify the
assets providing the security.
The excess of total current assets over total current liabilities is referred to as working capital (or
sometimes net working capital). Working capital represents the net amount of a company’s
relatively liquid resources. That is, it is the liquidity buffer available to meet the financial demands
of the operating cycle.
Companies seldom disclose on the statement of financial position an amount for working capital.
But bankers and other creditors compute it as an indicator of the short- run liquidity of a company.
To determine the actual liquidity and availability of working capital to meet current obligations,
however, requires analysis of the composition of the current assets and their nearness to cash.

4.4.2 Statement of Financial Position Format

As indicated earlier, IFRS does not specify the order or format in which a company presents items
in the statement of financial position. Thus, some companies present assets first, followed by equity,
and then liabilities. Other companies report current assets first in the assets section, and current
liabilities first in the liabilities section.
Many companies report items such as receivables and property, plant, and equipment net and then
disclose the additional information related to the contra accounts in the notes.
In general, companies use either the account form or the report form to present the statement of
financial position information. The account form lists assets, by sections, on the left side, and equity
and liabilities, by sections, on the right side. The main dis- advantage is the need for a sufficiently
wide space in which to present the items side by side. Often, the account form requires two facing
pages.
To avoid this disadvantage, the report form lists the sections one above the other, on the same page.
See, for example, Illustration below, which lists assets, followed by equity and liabilities directly
below, on the same page. Infrequently, companies use other statement of financial position
formats. For example, companies sometimes deduct current liabilities from current assets to arrive
at working capital. Or, they deduct all liabilities from all assets.

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 4.4.4 STATEMENT OF STOCKHOLDERS EQUITY
As we have discussed earlier, a statement of retained earnings explains the changes
that have occurred in retained earnings during an accounting period. However,
changes requiring disclosure also may occur in other components of stockholders’
equity, that is, paid-in capital. In such circumstances, a statement of stockholders’
equity, such as the one illustrated bellow for Union Company, also includes an
analysis of the changes in retained earnings:

UNION COMPANY
Statement of Stockholders’ Equity
For Years Ended December 31, Year 2 and Year 3
(In thousands)
Common Stock, $10 par
Number Additional Retained
of Shares Amount Paid-in earnings Total
capital
Balances, Jan.1.Year 2 1,250 $12,500 $137,858 $306,535 $456,893
Net income, Year 2 68,066 68,066
Cash dividends ($ 11 a share) ______ ______ ______ (13,750) (15,750)
Balances, Dec. 31, Year 2 1,250 $12,500 137,858 $360,851 $511,209
Net income Year 3 79,685 79,685
Cash dividends ($16 a share) (31,200) (31,200)
Issuance of common stock 283 2,830 24,332 27,162
Conversion of bonds payable
to common stock 417 4,170 30,315 34,485
50% stock dividend distributed 975 9,750 (9,750) _____
Balances, Dec. Year 3 2,925 $29,250 $192,505 $399,586 $621,341

4.5 STATEMENT OF CASH FLOWS

The statement of cash flows reports cash receipts, cash payments, and net change in
cash resulting from operating, investing, and financing activities of an enterprise
during a period, in a format that reconciles the beginning and ending cash balances.

The objectives of this statement are (1) to summarize the financing, operating, and
the investing activities of a business enterprise during an accounting period,
including the amount of cash and cash equivalents obtained from operations, and
(2) to complete the disclosure of changes in financial position during an accounting
period that are not readily apparent in comparative balance sheets.

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The primary purpose of the statement of cash flows is to provide information about
the entity’s cash receipts and cash payments during a period. A secondary objective
is to provide information on a cash basis about its operating, investing, and
financing activities. According to the FASB, the information provided in a statement
of cash flows, if used with related disclosures and the other financial statements
should help investors and creditors to:

 Assess the enterprises ability to generated positive future net cash flows
 Assess the enterprises ability to meet its obligations, its ability to pay
dividends, and its needs for external financing.
 Assess the reasons for differences between net income and associated cash
receipts and payments.
 Assess the effects on an enterprise’s financial position of both its cash and
non cash investing and financing transactions during a period.

The statement of cash flows provides information not available from other financial
statements. For example, it helps to indicate how it is possible for a company to
report a net loss and still make large capital expenditures or pay dividends. It can
tell whether the company issued or retired debt or common stock or both during the
period.

4.5.1. Contents of Statement of Cash Flows

Cash receipts and cash payment during a period are classified in the statement of
cash flows in to three different activities - operating, inviting, and financing
activities.

1. Operating activities: - involve the cash effects of transactions that enter into
the determination of net income.
2. Investing activates: - generally involves long-term assets. However, banks
and brokers are required to classify cash flows from purchases and sales of
loans and securities specifically for resale as operating activities. This
requirement recognizes that for these firms these assets are similar to
inventory in other businesses.
3. Financing activities: - Involve liability and stockholders’ equity items.

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To make the above classification more clear, you are given with the following
illustration that classifies the typical cash receipts and payments of a business
enterprise that are classified according to operating, investing, and financing
activities

As you can see from the table on the next page, some cash flows relating to investing
or financing activities are classified as operating activities. For example, receipts of
investment income (interest and dividends) and payments of interest to lenders are
classified as operating activities. Conversely, some cash flows relating to operating
activities are classified as investing or financing activities. For example the cash
received from the sale of property, plant, and equipment at a gain, although
reported in the income statement, is classified as an investing activity, and the effect
of the related gain would not be included in the net cash flows from operating
activities. Likewise, and a gain or loss on the payment (extinguishment) of debt
would generally be part of the cash outflow related to the payment of the amount
borrowed and therefore is a financing activity.

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 Operating
Cash inflows
From sale of goods or services
From returns on loans (interest) and on equity
securities (dividends)
Cash outflows Income statement
To supplies for inventory items
To employees for services
To government for taxes
To lenders for interest
To others for expenses
Investing
Cash inflows
From sale of property, plant, and equipment.
From sale of debt or equity securities of other Generally long-term
entities Asset Items
From collection of principal on loans to other entities
Cash outflows
To purchase property, plant, and equipment
To purchase debt or equity securities of other entities
To make loan to other entities
Financing
Cash outflows
From sale of equity securities Generally long-term
From issuance of debt (bonds and notes) liability and
Cash outflows equity items
To stock holders as dividends
To redeem long-term debt or reacquire capital
stock

The individual inflows and outflows from investing and financing activities are
reported separately, that is they are reported gross, not netted against one another.
Thus, cash outflow from the purchase of property is reported separately from the
cash inflows from the sale of property. Similarly, the cash inflow from the issuance
of debt is reported separately from the cash outflow from its retirement.

The basis recommended by the FASB for the statement of cash flows is actually ''
cash and cash equivalents''. Cash equivalents are short term, highly liquid
investments that are both readily convertible to known amount of cash and they
present insignificant risk of changes in interest rates. Generally, only investments
with original maturities of three months or less qualify under this identification.

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Examples of cash equivalents are treasury bills, commercial papers, and money
market funds purchased with cash that is in excess of immediate needs. In our
illustration in this portion, we mean cash and cash equivalents when repotting the
cash flows and the net increase or decrease in cash.

4.5.2 Steps in Preparation of Statement of Cash Flows

Unlike the other major financial statements, the statement of cash flows is not
prepared from the adjusted trial balances. The information to prepare this
statement usually comes from three sources:

Comparative balance sheets - provide the amount of the changes in assets,

liabilities, and equities form the beginning to the end of the period.
Current income statement - helps to determine the amount of cash provided
by or used by operations during the period.
Selected transaction data - data from the general ledger provide additional
detailed information needed to determine how cash was provided or used
during the period.

Preparing the statement of cash flows from the data sources above involves three
major steps. These steps are explained in the following section with an illustration
for GALAXY INC. The comparative balance sheet, income statement, and the
additional information required are given below:

GALAXY INC.
COMPARATIVE BALANCE SHEET
December 31, 2004
2004 2003 Change
Increase/Decrease
Assets
Cash $37,000 $49,000 $12,000 decrease
Account receivable 26,000 36,000 10,000 decrease
Prepaid expenses 6,000 -0- 6,000 increase
Land 70,000 -0- 70,000 increase
Building 200,000 -0- 200,000 increase
Accumulated depreciation-building (11,000) -0- 11,000 increase
Equipment 68,000 -0- 68,000 increase
Accumulated depreciation-equipment (10,000) -0- 10,000 increase
Total $386,000 $85,000

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 Liabilities and Stock holders’ Equity
Account Payable $ 40,000 $5,000 35,000 increase
Bond Payable 150,000 -0- 150,000 increase
Common stock ($1 par) 60,000 60,000 -0-
Retained Earnings 136,000 20,000 116,000 increase
Total $386,000 $85,000

GALAXY INC.
INCOME STATEMENT
For the Year Ended December 31, 2004

Revenue $ 492,000
Operating expenses (excluding depreciation) $269,000
Depreciation expense 21,000 290,000
Income from operations 202,000
Income tax expense 68,000
Net Income $134,000

Additional Information
1. In 2004, the company paid an $ 18,000 cash dividend.
2. The company obtained $150,000 cash through the issuance of long
term bonds.
3. Land, building, and equipment were acquired for cash.

Step 1:Determine the change in cash

To prepare a statement of cash flows, the first step is to determine the change in
cash. As indicated from the information presented in the above balance sheet, cash
decreased by 12,000 (49,000-37,000).

Step 2:Determine the Net Cash flow From Operating Activities.

A useful starting point in determine net cash flows from operating activities (net
cash flow provided or used by operating activities) is to understand why net
income must be converted from the accrual basis to the cash basis of accounting.
Under GAAP, most companies use the accrual basis of accounting. Net income may
include credit sales that have not been collected in cash and expenses incurred that
may not have been paid in cash. Thus, under the accrual basis of accounting, net
income will not indicate the net cash flow from operating activities.

To arrive at net cash provided (used) by operating activities, it is necessary to

report revenues and expenses on a cash basis. This is done by eliminating the effect
of income statement transactions that did not result in a corresponding increase or

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decreases in cash (non cash revenues and non cash expenses). The adjustment of
net income of $134,000 of GALAXY INC. on the accrual basis to arrive at the net cash
provided (used) by operating activities is explained below.

When account receivable decrease during the period, revenues on the cash basis are
higher than revenue on the accrual basis, because cash collections are higher than
revenues reported on the accrual basis. To convert net income (on accrual basis) to
net cash provided (used) by operating activities, the decrease of $10,000 in account
receivable must be added to net income.

When prepaid expenses (assets) increase during a period, expenses on an accrual

basis income statement are lower than they are on the cash basis of income
statement. Expenditures (cash payment) have been made in the current period, but
expenses (as charges to the income statement) have been deferred to future
periods. To convert net income to net cash provided (used) by operating activities,
the increase of $6,000 in prepaid expenses must be deducted from net income. An
increase in prepaid expenses results in a decrease in cash during the year

The increase of $35,000 in account payable in 2004 must be added to net income to
convert to net cash provided (used) by operating activities. . A greater amount of
expense was incurred than cash disbursed.

The purchase of depreciable assets is shown as a use of cash in the investing section
in the year of acquisition. The depreciation expense of $21,000 (also represented by
the increase in accumulated depreciation) is a non charge that is added back to net
income to arrive at net cash provided (used) by operating activities. The $21,000 is
the sum of the depreciation on the building of $11,000 and on the equipment of
$10,000. Other charges to expense for a period that do not require the use of cash
are treated in the same manner as depreciation.

Step 3:Determining net cash Flows from Investing and Financing activities
As indicated from the change in the land account, land of $70,000 was purchased
during the period. This transaction is an investing activity reported as a use of cash.
From the additional data and the change in the building account, an office building
was acquired using cash of $200,000. This transaction is a cash outflow reported in
the investing section. The increase in equipment is also treated in the same manner.

The Bond Payable account increased by $150,000. Receipts from the issuance of
these bonds represent an inflow of cash from financing activity. Retained earning
has also increased by $116,000 during the year. This increase can be explained by
two factors: (1) net income of $134,000 increased retained earnings;

Financial Accounting I – Chapter 1 16

(2) dividends of $18,000 decreased retained earnings. Payment of dividends is a
financing activity that involves a cash outflow.

Combining the foregoing items, we get a statement of cash flows for 2004 for
GALAXY INC., Presented below:
GALAXY INC.
STATEMENT OF CASH FLOWS
For the Year Ended December 31, 2004
Cash flow from operating activities
Net income …………………………………………………………………… 134,000
Items reconciling net income to net
Cash flow from operations:
Depreciation Expense………………………………………… 21, 000
Decrease in accounts receivable ………………………… 10,000
Increase in prepaid expenses …………………………… (6,000)
Increase in accounts payable …………………………… 35,000 60,000
Net cash provided by operating activities ………………… 194,000

Cash flow from investing activities

Purchase of land ……………………………......................... (70,000)
Purchase of building ……………………………………….. (200,000)
Purchase of equipment ……………………………………. (68,000)
Net cash used by investing activities ……………………………….. 338,000

Cash flow from financing activities

Issuance of bonds …………………. …………………….. 150,000
Payment of cash dividends ……………………………… (18,000)
Net cash provided by financing activities ……………………………… 132,000
Net decrease in cash ………………………………………………………... (12,000)
Cash, January 1, 2004 ……………………………………………………… 49,000
Cash, December 31, 2004…………………………………………………… 37,000

4.6 ADDITIONAL DISCLOSURE

As we have discussed in chapter one, the disclosure principle states that financial
statements should include all significant information needed by users of the
statement. If the omission information would cause the financial statements to be
misleading, disclosure of such information is essential.

Financial Accounting I – Chapter 1 17

The financial statements by themselves may not fully disclose all the necessary
information. Therefore
disclosure of additional information in the notes to financial statements may be
required. These notes are used to supplement the information in the body of the
financial statements but not to correct or justify improper presentation is the
statement. Some examples information often disclosed in the notes to financial
statements include the following:
- Summary of significant accounting policies
- Litigation in which the company is a party, loss and gain contingencies, and
unusual commitments.
- The amount of depreciation expense and research and development costs
- Description of stock option, pension, and employee stock ownership plans.
- Terms of proposed business combinations and a description of any unusual events
or transactions such as related party transactions.
Summary of Significant Accounting Policies
Information about the accounting policies adopted by a reporting entity is essential
for financial statement users. When financial statements are issued purporting to
present fairly financial position, changes in financial position, and results of
operations in accordance with GAAP, a description of all significant accounting
policies of the reporting entity should be included as an integral part of the financial
statements.

Examples of disclosure by a business enterprise in a separate section (or note) titled

“Summary of Significant Accounting Policies” include the following:

- Method or methods used to compute depreciation, depletion, and

amortization.
- Inventory costing
- Any change in accounting principles during the most recent accounting
period.
Adjustment of amount included in the financial statement is appropriate when
subsequent events provide evidence with respect to condition that existed on the
balance sheet date and materially affect financial statements (e.g. bankruptcy fitting
of major customers shortly after the balance sheet date).
Subsequent Events
The objective of providing users of financial statements with “full and complete
disclosure” cannot be achieved without considering material events and

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transactions that occur after the balance sheet date but before the financial
statements are issued. Such subsequent events may require either an adjustment of
amounts included in the financial statements or simply disclosure in a note to the
financial statements.

Adjustments of amounts included in the financial statements is required as a result

of subsequent events that provide evidence with respect to conditions that existed
on the balance sheet date and materially affect the financial statements. Information
that becomes available prior to the issuance of financial statements should be used
by management and independent accountants to measure assets, liabilities,
revenues, and expenses reported in the statements. For example, the filling for
bankruptcy by a major customer shortly after the balance sheet date resulting in a
material uncollectible trade receivable would be indicative of conditions existing on
that date.
Other examples of subsequent events that do not require adjustment of the financial
statements, but require disclosure, are listed below:

- Issuance of material amount of bonds or capital stock

- Filing of settlement of important litigation
- Casual losses and any other events that may have a material financial impact
on the reporting entity

The supplementary disclosures in financial statements may also be required to

provide a more detailed insight to users of the information. The three special types
of supplementary disclosures are interim reports of earnings, segment reporting,
and prospective financial statements and forecasts.

ADDITIONAL INFORMATION
IFRS requires that a complete set of financial statements be presented annually.
Determine additional information requiring note disclosure.

Along with the current year’s financial statements, companies must also provide
comparative information from the previous period. In other words, two complete
sets of financial statements and related notes must be reported.
A complete set of financial statements comprise the following.
1. A statement of financial position at the end of the period;
2. A statement of comprehensive income for the period to be presented either as:
(a) One single statement of comprehensive income.
(b) A separate income statement and statement of comprehensive income. In this
situation, the income statement is presented first.

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3. A statement of changes in equity;
4. A statement of cash flows; and
5. Notes, comprising a summary of significant accounting policies and other
explanatory information.

However, the primary financial statements cannot provide the complete picture
related to the financial position and financial performance of the company.
Descriptive information is also required by IFRS in the notes to the financial
statements to amplify or explain the items presented in the main body of the
statements.

Notes to the Financial Statements

As indicated earlier, notes are an integral part of reporting financial statement

information. Notes can explain in qualitative terms information related to specific
financial statement items. In addition, they can provide supplemental data of a
quantitative nature to expand the information in financial statements. Notes also
can explain restrictions imposed by financial arrangements or basic contractual
agreements. Although notes may be technical and difficult to understand in some
cases, they provide meaningful information for the user of the financial statements.

Accounting Policies
Accounting policies are the specific principles, bases, conventions, rules, and
practices applied by a company in preparing and presenting financial information.
The IASB recommends disclosure for all significant accounting principles and
methods that involve selection from among alternatives or those that are peculiar to
a given industry. For in- stance, companies can compute inventories under several
cost flow assumptions (e.g., average-cost and FIFO), depreciate plant and equipment
under several accepted methods (e.g., double-declining balance and straight-line),
and carry investments at different valuations (e.g., cost, equity, and fair value).
Sophisticated users of financial statements know of these possibilities and examine
the statements closely to determine the methods used.
Companies therefore present a “Summary of Significant Accounting Policies”
generally as the first note to the financial statements. This disclosure is important
because, under IFRS, alternative treatments of a transaction are sometimes
permitted. If these policies are not understood, users of the financial statements are
not able to use the financial statements to make comparisons among companies.
Here are some examples of various accounting policies adapted from companies’
annual reports.
Additional Notes to the Financial Statements In addition to a note related to
explanation of the companies’ accounting policies, companies use specific notes to

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discuss items in the financial statements. Judgment must be exercised to identify the
important aspects of financial information that need amplification in the notes. In
many cases, IFRS requires specific disclosures. For example, using the statement of
financial position as an example, note disclosures include:

1. Items of property, plant, and equipment are disaggregated in to classes such as

land, buildings, etc., in the notes, with related accumulated depreciation reported
where applicable.
2. Receivables are disaggregated in to amounts receivable from trade customers,
receivables from related parties, prepayments, and other amounts.
3. Inventories are disaggregated into classifications such as merchandise,
production supplies, work in process, and finished goods.
4. Provisions are disaggregated into provisions for employee benefits and other
items.

In addition, there are often schedules and computations required by a specific

standard. For example, for receivables, IFRS requires a maturity analysis for
receivables.
Techniques of Disclosure
Companies should disclose as completely as possible the effect of various
uncertainties on financial condition, the methods of valuing assets and liabilities,
and the company’s contracts and agreements. To disclose this pertinent
information, Parenthetical Explanations
Companies often provide additional information by parenthetical explanations
following the item
Example

This additional pertinent statement of financial position information adds clarity

and completeness. It has an advantage over a note because It brings the additional
information in to the body of the statement where readers will less likely over
look it. Companies, however, should avoid lengthy parenthetical explanations,
which might be distracting.

Cross-Reference and Contra Items

Companies “cross-reference” a direct relationship between an asset and a liability
on the statement of financial position. For example, as shown in

Financial Accounting I – Chapter 1 21

 Illustration 5-38, on December 31, 2015, accompany might show the following entries
—one listed among the current assets, and the other listed among the current
liabilities.
Example:

This cross-reference points out that the company will redeem $2,300,000 of bonds
payable currently, for which it has only set aside $800,000. Therefore, it needs
additional cash from unrestricted cash, from sales of investments, from profits, or
from some other source. Alternatively, the company can show the same information
parenthetically.
Another common procedure is to establish contra or adjunct accounts. A contra
account on a statement of financial position reduces an asset, liability, or equity
account. Examples include Accumulated Depreciation and Allowance for Doubtful
Accounts. Contra accounts provide some flexibility in presenting the financial
information. With the use of the Accumulated Depreciation account, for example, a
reader of the statement can see the original cost of the asset as well as the
depreciation to date.
An adjunct account, on the other hand, increases an asset, liability, or equity account.
An example is Fair Value Adjustment, which, when added to the Non-Trading Equity
Investment account, describes the total investment asset of the company.

Other Guidelines
In addition to the specifics related to individual financial statements and notes to
these statements, IASNo.1 also addresses important issues related to presentation
Off setting
IASNo.1 indicates that it is important that assets and liabilities, and income and
expense, be reported separately. Otherwise, it may be difficult for users to understand
the transactions or events that occurred at the company. Therefore, it is improper for
a company like Sinopec (CHN) to offset accounts payable against cash. Similarly, it is
improper for Sinopec to offset debt used to purchase buildings against the buildings
on the statement of financial position. However, it is proper for Sinopec to measure
assets net of valuation allowances, such as allowance for doubtful accounts or
inventory net of impairment. In these cases, the company is simply reporting the
appropriate value on the financial statement, and therefore it is not considered
offsetting. In general, unless a specific IFRS permits offsetting, it is not permitted.

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Consistency

The Conceptual Framework discussed in Chapter 1 notes that one of the enhancing
qualitative characteristics is comparability. As part of comparability, the Conceptual
Framework indicates that companies should follow consistent principles and methods
from one period to the next. As a result, accounting policies must be consistently
applied for similar transactions and events unless an IFRS requires a different policy.
Thus, Woolworths (AUS), which uses the straight-line method for depreciating
property, plant, and equipment, reports on the straight-line method for all periods
presented.
Fair Presentation
Companies must present fairly the financial position, financial performance, and cash
flows of the company. Fair presentation means the faithful representation of
transactions and events using the definitions and recognition criteria in the
Conceptual Frame- work. It is presumed that the use of IFRS with appropriate
disclosure results in financial statements that are fairly presented. In other words, in
appropriate use of accounting policies cannot be overcome by explanatory notes to
the financial statements.
In some rare cases, as indicated in Chapter 1, companies can use a “true and fair” over-
ride. This situation develops, for example, when the IFRS for a given company appears
to conflict with the objective of financial reporting. This situation might occur when a
regulatory body indicates that a specific IFRS may be misleading

Financial Accounting I – Chapter 1 23