Chapter 5: Financial Position and Cash Flows

Statement of Financial Position (SFP): Usefulness

- AKA balance sheet under ASPE

- SFP Provides information to users:

o For calculating rates of return on invested assets
o For evaluating the capital structure
o On liquidity (amount of time until an asset is converted to cash)
o On solvency (ability to pay debts and related interest)
o About financial flexibility
 Ability to respond to unexpected needs/opportunities

Statement of Financial Position (SFP): Limitations

- Many assets and liabilities are stated at historical cost
o Info presented has higher reliability
 However, reporting at current fair value would result in more relevant info

- Judgement and estimates are used in determining many of the items reported in the SFP
o Many “soft” numbers (estimates) at included that could be significantly uncertain
o Materiality judgements often needed

- SFP leaves out many items that cannot be recorded objectively or are off-balance sheet

Classes of Items on the Statement of Financial Position:

- Assets: present economic resources controlled by a company as a result of past
transactions/events with the potential to produce future economic benefits.

- Liabilities: present duty or responsibility that obligates the company to transfer an

economic resource
o Arising from past transaction/event and cannot be avoided

- Equity/Net Assets: residual interest in an entity’s assets after deducting its liabilities
o the value of a company's assets once the value of its liabilities has been
deducted.

- SFP shows classes in order:

o Assets
o Liabilities
o Equity
 - IFRS allows order to be reversed

Elements of the SFP:

Assets Liabilities and Equity
- Current Assets - Current liabilities
- Long – term investments - Long term debt
- Property, plant, and equipment (PPE) - Shareholders’ equity
- Intangible assets - Capital Shares
- Other assets - Contributed Surplus
- Retained Earnings
- Accumulated Other
Comprehensive Income / other surplus

Current Assets:
- Current assets are cash and other assets expected to be realized:
o Within one year from date of SFP
o Within normal operating cycle, whichever is longer

- First on SFP

- Presented in order of liquidity

o Cash, short term investments, receivables, inventory, and prepaid items

Current Assets – Cash:

- Includes cash and cash equivalents

- Defined as:
o Cash, demand deposits, short-term highly liquid investments readily convertible
into known amounts of cash
o Have insignificant risk of changing in value

Current Assets – Short-Term Investments:

- Investments in debt/equity securities are presented separately from other assets

- Short term if expected to be sold or realized within 12 months of SFP date

o Or held for trading

- Valued at cost/amortized cost or fair value

- Companies with excess cash have significant amount of short-term investment

Current Assets – Receivables:
- Amounts should be reported separately based on nature of their origin:
o Ordinary trade accounts
o Amounts owing by related parties
o Other (substantial) unusual items

- Anticipated losses due to uncollectibles should be accrued

- Separate disclose required for:

o Amount/nature of nontrade receivables
o Receivables pledged as collateral

- Accounts receivable valued at net realizable value (NRV)

o NRV - net amount a company is able to sell an asset for or collect as part of an
existing agreement

Current Assets – Inventories:

- Assets that are:
o Held for sale in the ordinary course of business
o In process of production for sale
o In form of materials/supplies to be consumed in production process or in
rendering of service

- Valued at lower of cost and net realizable value with cost formula disclosed (FIFO,
weighted average)

- Manufacturing enterprise should disclose complete stage of inventories for

o Raw materials, WIP, finished Goods

Current Assets – Prepaid Expenses:

- Prepaid Expenses: expenditures already made for benefits (services) that will be
received within one year or operating cycle (whichever is longer)

- Reported as unexpired or unconsumed cost

- Common prepaid expenses:

o Rent
o Advertising
o Property taxes
o Office or operating supplies
 - Current practice to report some prepaid amounts as current assets even if benefit
extends beyond one year

Non-current Investments:
- Presented on SFP bellow current assets in separate section called “Investments”

- Investments that will be held for an extended period

o >1 year or operating cycle

- Valuations options are:

o Fair value, amortized cost, equity method

Property, Plant, and Equipment (PPE):

- Physical (tangible) assets used in on-going business operations of the business to
generate income
o Tangible asset - an asset that has physical substance.

- Land, buildings, machinery, furniture, wasting resources

- Reported at cost or amortized cost

o Amortized Cost - accumulated portion of the recorded cost of a fixed asset that
has been charged to expense through either depreciation or amortization

o Amortization - an accounting method for spreading out the costs for the use of a
long-term asset over the expected period the long-term asset will provide value

- IFRS allows options for valuation at fair value

- Most assets are depreciable

o Except for land

Intangible Assets & Goodwill:

- Intangible Assets: are capital assets without physical substance

- Patents, copyrights, franchises, trademark, trade names

- Initially recorded at cost, and tested for impairment

- Intangibles are grouped into two categories:

o Finite life – amortized over useful life
o Indefinite life – not amortized
 - Goodwill arises in a business combination
o Is not amortized
o Tested for impairment

Current Liabilities:
- Obligations due within one year (from date of SFP) or within operating cycle

- Examples:
o Payables resulting from acquisitions of goods/services
o Collections received in advance of deliver of goods or performance of services
o Other liabilities to be paid in the short term
o Short term financing payable on demand

- Accounts payable normally listed first

o Current liabilities are not reported in any specific order

Working Capital:
- Total Current Assets – Total Current Liabilities = Working Capital

- Key indicator of company’s short-term liquidity

- Not disclosed on SFP

Long Term Liabilities:

- Long term obligations are those not reasonably expected to be liquidated within normal
operating cycle
o Liquidated - converting property or assets into cash or cash equivalents by selling
them on the open market.

- Three types:
o From specific financing situations
 Bonds
o From ordinary enterprise operations
 Pension
o Depending on occurrence or non-occurrence of one or more future evets
(warranty)

- Presentation requires reporting the portion due within next year as current liability
Owners’/Shareholders’ Equity:
- Consists of Four Parts:
o Capital Share – issues shares
 Disclose the number of authorized, issued and outstanding shares

o Contributed Surplus – issued share premiums

o Retained Earnings – undistributed accumulated earnings/losses

o Accumulated other Comprehensive Income (IFRS)

Purpose and Content of a Statement of Cash Flows:

- To assess the firm’s capacity to generate cash/cash equivalents

- To enable users to compare the operating performance and cash flows of different
entities

- Statement of cash flows shows:

o Where the cash came from
o What the cash was used for
o What was the change in the cash balance

Format of a Statement of Cash Flows:

- Cash Flow activities are divided into three sections
o Operating Activities
 Main revenue-producing activities

o Investing Activities
 Acquisitions and disposal disposals of long-term assets and other
investments

o Financing Activities
 Changes in equity and borrowings
Cash Inflows and Outflows:

Preparation Methods for Statement of Cash Flows:

- Direct Method
o Restates operations on a cash basis
 Includes specific cash inflows/outflows
 Cash received from customers
 Cash paid to suppliers/employees
 Interest paid/received
 Taxes paid

- Indirect Method
o Reconciles accrual net income to cash-based net income
 Adds back non-cash charges deducted from net income
 Such as depreciation

 Accrual net income - calculated by adding up all revenues generated

during a given period and subtracting all related expenses incurred within
the same timeframe

- Only the operating activities sections differ between the two methods

Perspectives – Cash Flow Patterns:

- Refers to positive or negative cash flows from operating, investing and financing
activities
 - Cash flow patterns can reveal significant information:
o Company with (+ - +) pattern is raising funds in marketplace which shows they
are supported and likely ability to prosper

o Company with (- + +) may be selling off revenue-producing assets to finance

operations
 Jeopardizing revenue producing potential

o Capital asset purchases are financed through operations solvency risk does not
increase

Perspectives – Free Cash Flow:

- Calculated as net cash from operations minus capital expenditures and dividends

- Indicates discretionary cash flow (cash left to invest or expand) to make additional
investments, to retire debt, or to add to liquidity

- Free cash flow analysis answers questions:

o Can the company pay dividends without external financing?
o If operations decline, will company be able to main its required capital
investment?