Hey, It Doesn't Balance!

A good accounting student knows by now that Total Assets = Total Liabilities + Total Equity. From this equation, we can also determine net assets, which are determined as follows: Total Assets − Total Liabilities = Net Assets. O.K., this is simple so far. But let's look at the discussion paper by the IASB on how the statement of financial position (often referred to as the balance sheet) should be structured.

The statement of financial position is divided into five major parts, with many assets and liabilities netted against one another. Here is the general framework for the new statement of financial position:

The statement does look a bit different than the traditional balance sheet. Let's put some numbers to the statement and see how it works. (See the example on the facing page.)

Well, it does balance—in that net assets equal equity—but isn't it important to know total assets and total liabilities? As some have observed, the statement of financial position will not balance the way we expect it to. That is, assets won't equal liabilities and equity. This is because the assets and liabilities are grouped into the business, financing, discontinued operations, and income taxes categories. This new model raises a number of questions, such as:

• Does separating “business activities” from “financing activities” provide information that is more decision-useful?
• Does information on income taxes and discontinued operations merit separate categories?

The IASB is working to get answers to these and other questions about this proposed model. One thing is for sure—adoption of the new financial statement will be a dramatic change but hopefully one for the better.

Sources: Marie Leone and Tim Reason, “How Extreme Is the Makeover?” CFO Magazine (March 1, 2009); and Preliminary Views on Financial Statement Presentation, FASB/IASB Discussion Paper (October 2008).

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.¹ 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 risk² 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 a company, like adidas (DEU), will have the resources 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 adidas' liquidity, the lower its risk of failure.

Solvency refers to the ability of a company 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.

Limitations of the Statement of Financial Position

See the Authoritative Literature section (page 215).

Some of the major limitations of the statement of financial position are:

1. 1. 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. For example, Pemex (MEX) owns crude oil and natural gas that may appreciate in value. Yet, it reports any increase only if and when it sells the assets.
2. 2. Companies use judgments and estimates to determine many of the items reported in the statement of financial position. For example, in its statement of financial position, Lenovo (CHN) estimates the amount of receivables that it will collect, the useful life of its warehouses, and the number of computers that will be returned under warranty.
3. 3. 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.

The bankruptcy of Enron (USA), the seventh-largest U.S. company at the time, highlights the omission of important items in the statement of financial position. In Enron's case, it failed to disclose certain off-balance-sheet financing obligations in its main financial statements.

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. 1. Assets and liabilities with different general liquidity characteristics. For example, Nokia (FIN) reports cash separately from inventories.
2. 2. Assets that differ in their expected function in the company's central operations or other activities. For example, Puma (DEU) reports merchandise inventories separately from property, plant, and equipment. Similarly, a company like Marks and Spencer plc (GBR) that uses assets in its operations should report these assets differently from assets held for investments and assets subject to restrictions, such as leased facilities.
3. 3. Liabilities that differ in their amounts, nature, and timing. For example, Royal Ahold (NLD) should report accounts payable separately from its pension liability.

The three general classes of items included in the statement of financial position are assets, liabilities, and equity. We defined them in Chapter 2 as follows.³

Companies then further divide these items into several subclassifications. Illustration 5-1 indicates the general format of statement of financial position presentation.

ILLUSTRATION 5-1
Statement of Financial Position Classification

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:

1. 1. Investments in securities, such as bonds, ordinary shares, or long-term notes.
2. 2. Investments in tangible assets not currently used in operations, such as land held for speculation.
3. 3. Investments set aside in special funds, such as a sinking fund, pension fund, or plant expansion fund.
4. 4. Investments in non-consolidated subsidiaries or associated companies.

Companies group investments in debt and equity securities into 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).

We further discuss the held-for-collection and non-trading equity securities in Chapter 17.⁴

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, 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.[3]

Christian Dior (FRA) reported its investments as follows.

ILLUSTRATION 5-2
Statement of Financial Position Presentation of Long-Term Investments

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, a company either depreciates (e.g., buildings) or depletes (e.g., oil reserves) these assets.

ÆON Co. Ltd. (JPN) presented its property, plant, and equipment in its statement of financial position as shown in Illustration 5-3 (on page 186).

ILLUSTRATION 5-3
Statement of Financial Position Presentation of Property, Plant, and Equipment

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.⁵ 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.

Nokia (FIN) reported intangible assets in its statement of financial position as follows.

ILLUSTRATION 5-4
Statement of Financial Position Presentation of Intangible Assets

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 Illustration 5-5. These assets are generally presented in the following order.

ILLUSTRATION 5-5
Current Assets and Basis of Valuation

A 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, a company 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 into 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 a non-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 current 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 a company consumes plant assets during the operating cycle. Conceptually, it seems that a company 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, a company discloses the basis of valuation (e.g., lower-of-cost-or-net realizable value) and the cost flow assumption used (e.g., FIFO or average-cost). Presented in Illustration 5-6 is how Royal Ahold (NLD) reports its inventories.

ILLUSTRATION 5-6
Statement of Financial Position Presentation of Inventories

A manufacturing company, like Acer Incorporated (TWN), also indicates the stage of completion for inventory, as shown in Illustration 5-7. Note that Acer shows amounts both in New Taiwan dollars (NT$) and U.S. dollars ($).

ILLUSTRATION 5-7
Statement of Financial Position Presentation of Inventories

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. Reed Elsevier (GBR) reported its receivables as shown in Illustration 5-8.

ILLUSTRATION 5-8
Statement of Financial Position Presentation of Receivables

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. adidas (DEU) reports prepaid expenses in other current assets, along with tax receivables other than income taxes and derivative financial assets, as shown in Illustration 5-9.

ILLUSTRATION 5-9
Statement of Financial Position Presentation of Prepaid Expenses

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.⁶

Illustration 5-10 provides an excerpt from the annual report of AB InBev (BEL) with respect to its short-term financial assets.

ILLUSTRATION 5-10
Statement of Financial Position Presentation of Short-Term Investments

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. As an example, see the excerpt from adidas (DEU) in Illustration 5-11.

ILLUSTRATION 5-11
Statement of Financial Position Presentation of Cash and Cash Equivalents

A company must disclose any restrictions or commitments related to the availability of cash. If a company restricts cash for purposes other than current obligations, it excludes the cash from current assets. Illustration 5-12 shows an example of this, from the annual report of Vodafone plc (GBR).

ILLUSTRATION 5-12
Statement of Financial Position Presentation of Restricted Cash

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 unappropriated (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.

Illustration 5-13 presents an example of the equity section for Delhaize Group (BEL).

ILLUSTRATION 5-13
Statement of Financial Position Presentation of Equity

Many companies reporting under IFRS often use the term “reserve” as an all-inclusive catch-all for items such as retained earnings, share premium, and accumulated other comprehensive income. An example of such a presentation is shown for Lenovo Group Limited (CHN).

ILLUSTRATION 5-14
Statement of Financial Position Presentation of Reserves

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.

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:

1. 1. Obligations arising from specific financing situations, such as the issuance of bonds, long-term lease obligations, and long-term notes payable.
2. 2. Obligations arising from the ordinary operations of the company, such as pension obligations and deferred income tax liabilities.
3. 3. 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. Illustration 5-15 provides an example of this, taken from an excerpt from Silver Fern Farms Limited's (NZL) financials.

ILLUSTRATION 5-15
Statement of Financial Position Presentation of Non-Current Liabilities

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. 1. Payables resulting from the acquisition of goods and services: accounts payable, salaries and wages payable, income taxes payable, and so on.
2. 2. Collections received in advance for the delivery of goods or performance of services, such as unearned rent revenue or unearned subscriptions revenue.
3. 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 a long-term basis before the end of the reporting period. [6] 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. For example, see Siemens AG's (DEU) current liabilities section in Illustration 5-16 (on page 194).

ILLUSTRATION 5-16
Statement of Financial Position Presentation of Current Liabilities

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 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.

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 (see the “What do the numbers mean?” box on page 184). 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 disadvantage 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 5-17, 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.

ILLUSTRATION 5-17
Classified Report-Form Statement of Financial Position

STATEMENT OF CASH FLOWS

Chapter 2 indicated that an important element of the objective of financial reporting is “assessing the amounts, timing, and uncertainty of cash flows.” The three financial statements we have looked at so far—the income statement (or statement of comprehensive income), the statement of changes in equity, and the statement of financial position—each present some information about the cash flows of an enterprise during a period. But they do so to a limited extent. For instance, the income statement provides information about resources provided by operations but not exactly cash. The statement of changes in equity shows the amount of cash used to pay dividends or purchase treasury shares. Comparative statements of financial position might show what assets the company has acquired or disposed of and what liabilities it has incurred or liquidated.

Useful as they are, none of these statements presents a detailed summary of all the cash inflows and outflows, or the sources and uses of cash during the period. To fill this need, the IASB requires the statement of cash flows (also called the cash flow statement).[7]

Purpose of the Statement of Cash Flows

The primary purpose of the statement of cash flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period. To achieve this purpose, the statement of cash flows reports the following: (1) the cash effects of operations during a period, (2) investing transactions, (3) financing transactions, and (4) the net increase or decrease in cash during the period.⁷

Reporting the sources, uses, and net increase or decrease in cash helps investors, creditors, and others know what is happening to a company's most liquid resource. Because most individuals maintain a checkbook and prepare a tax return on a cash basis, they can comprehend the information reported in the statement of cash flows.

The statement of cash flows provides answers to the following simple but important questions:

1. 1. Where did the cash come from during the period?
2. 2. What was the cash used for during the period?
3. 3. What was the change in the cash balance during the period?

Content and Format of the Statement of Cash Flows

Companies classify cash receipts and cash payments during a period into three different activities in the statement of cash flows—operating, investing, and financing activities, defined as follows.

1. 1. Operating activities involve the cash effects of transactions that enter into the determination of net income.
2. 2. Investing activities include making and collecting loans and acquiring and disposing of investments (both debt and equity) and property, plant, and equipment.
3. 3. Financing activities involve liability and equity items. They include (a) obtaining resources from owners and providing them with a return on their investment, and (b) borrowing money from creditors and repaying the amounts borrowed.

Illustration 5-18 shows the basic format of the statement of cash flows.

ILLUSTRATION 5-18
Basic Format of Cash Flow Statement

Illustration 5-19 graphs the inflows and outflows of cash classified by activity.

ILLUSTRATION 5-19
Cash Inflows and Outflows

The statement's value is that it helps users evaluate liquidity, solvency, and financial flexibility. As stated earlier, liquidity refers to the “nearness to cash” of assets and liabilities. Solvency is the firm's ability to pay its debts as they mature. Financial flexibility is a company's ability to respond and adapt to financial adversity and unexpected needs and opportunities.

We have devoted Chapter 23 entirely to the detailed preparation and content of the statement of cash flows. The intervening chapters will cover several elements and complex topics that affect the content of a typical statement of cash flows. The presentation in this chapter is introductory—a reminder of the existence of the statement of cash flows and its usefulness.

Overview of the Preparation of the Statement of Cash Flows

Sources of Information

Companies obtain the information to prepare the statement of cash flows from several sources: (1) comparative statements of financial position, (2) the current income statement, and (3) selected transaction data.

The following simple example demonstrates how companies use these sources in preparing a statement of cash flows.

On January 1, 2015, in its first year of operations, Telemarketing Inc. issued 50,000 ordinary shares of $1 par value for $50,000 cash. The company rented its office space, furniture, and telecommunications equipment and performed marketing services throughout the first year. In June 2015, the company purchased land for $15,000. Illustration 5-20 shows the company's comparative statements of financial position at the beginning and end of 2015.

ILLUSTRATION 5-20
Comparative Statements of Financial Position

Illustration 5-21 presents the income statement and additional information.

ILLUSTRATION 5-21
Income Statement Data

Preparing the Statement of Cash Flows

Preparing the statement of cash flows from these sources involves four steps:

1. 1. Determine the net cash provided by (or used in) operating activities.
2. 2. Determine the net cash provided by (or used in) investing and financing activities.
3. 3. Determine the change (increase or decrease) in cash during the period.
4. 4. Reconcile the change in cash with the beginning and the ending cash balances.

Net cash provided by operating activities is the excess of cash receipts over cash payments from operating activities. Companies determine this amount by converting net income on an accrual basis to a cash basis. To do so, they add to or deduct from net income those items in the income statement that do not affect cash. This procedure requires that a company analyze not only the current year's income statement but also the comparative statements of financial position and selected transaction data.

Analysis of Telemarketing's comparative statements of financial position reveals two items that will affect the computation of net cash provided by operating activities:

1. 1. The increase in accounts receivable reflects a non-cash increase of $41,000 in revenues.
2. 2. The increase in accounts payable reflects a non-cash increase of $12,000 in expenses.

Therefore, to arrive at net cash provided by operating activities, Telemarketing Inc. deducts from net income the increase in accounts receivable ($41,000), and it adds back to net income the increase in accounts payable ($12,000). As a result of these adjustments, the company determines net cash provided by operating activities to be $10,000, computed as shown in Illustration 5-22.

ILLUSTRATION 5-22
Computation of Net Cash Provided by Operating Activities

Next, the company determines its investing and financing activities. Telemarketing Inc.'s only investing activity was the land purchase. It had two financing activities. (1) Share capital—ordinary increased $50,000 from the issuance of 50,000 ordinary shares for cash. (2) The company paid $14,000 cash in dividends. Knowing the amounts provided/used by operating, investing, and financing activities, the company determines the net increase in cash. Illustration 5-23 presents Telemarketing Inc.'s statement of cash flows for 2015.

ILLUSTRATION 5-23
Statement of Cash Flows

The increase in cash of $31,000 reported in the statement of cash flows agrees with the increase of $31,000 in cash calculated from the comparative statements of financial position.⁸

Significant Non-Cash Activities

Not all of a company's significant activities involve cash. Examples of significant non-cash activities are:

1. 1. Issuance of ordinary shares to purchase assets.
2. 2. Conversion of bonds into ordinary shares.
3. 3. Issuance of debt to purchase assets.
4. 4. Exchanges of long-lived assets.

Significant financing and investing activities that do not affect cash are not reported in the body of the statement of cash flows. Rather, these activities are reported in a separate note to the financial statements. Such reporting of these non-cash activities satisfies the full disclosure principle.

Illustration 5-24 shows an example of a comprehensive statement of cash flows. Note that the company purchased equipment through the issuance of €50,000 of bonds, which is a significant non-cash transaction. For homework purposes, you should present significant non-cash activities in a separate note entitled “Cash Flow Note.”

ILLUSTRATION 5-24
Comprehensive Statement of Cash Flows

Usefulness of the Statement of Cash Flows

“Happiness is a positive cash flow” is certainly true. Although net income provides a long-term measure of a company's success or failure, cash is its lifeblood. Without cash, a company will not survive. For small and newly developing companies, cash flow is the single most important element for survival. Even medium and large companies must control cash flow.

Creditors examine the cash flow statement carefully because they are concerned about being paid. They begin their examination by finding net cash provided by operating activities. A high amount indicates that a company is able to generate sufficient cash from operations to pay its bills without further borrowing. Conversely, a low or negative amount of net cash provided by operating activities indicates that a company may have to borrow or issue equity securities to acquire sufficient cash to pay its bills. Consequently, creditors look for answers to the following questions in the company's cash flow statements.

1. 1. How successful is the company in generating net cash provided by operating activities?
2. 2. What are the trends in net cash flow provided by operating activities over time?
3. 3. What are the major reasons for the positive or negative net cash provided by operating activities?

You should recognize that companies can fail even though they report net income. The difference between net income and net cash provided by operating activities can be substantial. Companies sometimes report high net income numbers but negative net cash provided by operating activities. This type of situation can eventually lead to bankruptcy.

In addition, substantial increases in receivables and/or inventory can explain the difference between positive net income and negative net cash provided by operating activities. For example, in its first year of operations Hu Inc. reported a net income of HK$80,000. Its net cash provided by operating activities, however, was a negative HK$95,000, as shown in Illustration 5-25.

ILLUSTRATION 5-25
Negative Net Cash Provided by Operating Activities

Hu could easily experience a “cash crunch” because it has its cash tied up in receivables and inventory. If Hu encounters problems in collecting receivables, or if inventory moves slowly or becomes obsolete, its creditors may have difficulty collecting on their loans.

Financial Liquidity

Readers of financial statements often assess liquidity by using the current cash debt coverage. It indicates whether the company can pay off its current liabilities from its operations in a given year. Illustration 5-26 shows the formula for this ratio.

ILLUSTRATION 5-26
Formula for Current Cash Debt Coverage

The higher the current cash debt coverage, the less likely a company will have liquidity problems. For example, a ratio near 1:1 is good. It indicates that the company can meet all of its current obligations from internally generated cash flow.

Financial Flexibility

The cash debt coverage provides information on financial flexibility. It indicates a company's ability to repay its liabilities from net cash provided by operating activities, without having to liquidate the assets employed in its operations. Illustration 5-27 shows the formula for this ratio. Notice its similarity to the current cash debt coverage. However, because it uses average total liabilities in place of average current liabilities, it takes a somewhat longer-range view.

ILLUSTRATION 5-27
Formula for Cash Debt Coverage

The higher this ratio, the less likely the company will experience difficulty in meeting its obligations as they come due. It signals whether the company can pay its debts and survive if external sources of funds become limited or too expensive.

Free Cash Flow

A more sophisticated way to examine a company's financial flexibility is to develop a free cash flow analysis. Free cash flow is the amount of discretionary cash flow a company has. It can use this cash flow to purchase additional investments, retire its debt, purchase treasury shares, or simply add to its liquidity. Financial statement users calculate free cash flow as shown in Illustration 5-28.

ILLUSTRATION 5-28
Formula for Free Cash Flow

In a free cash flow analysis, we first deduct capital spending to indicate it is the least discretionary expenditure a company generally makes. (Without continued efforts to maintain and expand facilities, it is unlikely that a company can continue to maintain its competitive position.) We then deduct dividends. Although a company can cut its dividend, it usually will do so only in a financial emergency. The amount resulting after these deductions is the company's free cash flow. Obviously, the greater the amount of free cash flow, the greater the company's amount of financial flexibility.

Questions that a free cash flow analysis answers are:

1. 1. Is the company able to pay its dividends without resorting to external financing?
2. 2. If business operations decline, will the company be able to maintain its needed capital investment?
3. 3. What is the amount of discretionary cash flow that can be used for additional investment, retirement of debt, purchase of treasury shares, or addition to liquidity?

Illustration 5-29 is a free cash flow analysis using the cash flow statement for Nestor Company (shown in Illustration 5-24 on page 201).

ILLUSTRATION 5-29
Free Cash Flow Computation

This computation shows that Nestor has a positive, and substantial, net cash provided by operating activities of €411,750. Nestor's statement of cash flows reports that the company purchased equipment of €182,500 and land of €70,000 for total capital spending of €252,500. Nestor has more than sufficient cash flow to meet its dividend payment and therefore has satisfactory financial flexibility.

As you can see from looking back at Illustration 5-24 (on page 201), Nestor used its free cash flow to redeem bonds and add to its liquidity. If it finds additional investments that are profitable, it can increase its spending without putting its dividend or basic capital spending in jeopardy. Companies that have strong financial flexibility can take advantage of profitable investments even in tough times. In addition, strong financial flexibility frees companies from worry about survival in poor economic times. In fact, those with strong financial flexibility often fare better in a poor economy because they can take advantage of opportunities that other companies cannot.

ADDITIONAL INFORMATION

IFRS requires that a complete set of financial statements be presented annually. 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. 1. A statement of financial position at the end of the period;
2. 2. A statement of comprehensive income for the period to be presented either as:
   1. (a) One single statement of comprehensive income.
   2. (b) A separate income statement and statement of comprehensive income. In this situation, the income statement is presented first.
3. 3. A statement of changes in equity;
4. 4. A statement of cash flows; and
5. 5. Notes, comprising a summary of significant accounting policies and other explanatory information. [8]

Chapters 4 and 5 discussed the first four items. 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 instance, 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.

ILLUSTRATION 5-30
Accounting Policies—Inventory

ILLUSTRATION 5-31
Accounting Policies—Intangible Asset

ILLUSTRATION 5-32
Accounting Policies—Property, Plant, and Equipment

ILLUSTRATION 5-33
Accounting Policies—Financial Liabilities

Additional Notes to the Financial Statements

In addition to a note related to explanation of the companies' accounting policies, companies use specific notes to 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. 1. Items of property, plant, and equipment are disaggregated into classes such as land, buildings, etc., in the notes, with related accumulated depreciation reported where applicable.
2. 2. Receivables are disaggregated into amounts receivable from trade customers, receivables from related parties, prepayments, and other amounts.
3. 3. Inventories are disaggregated into classifications such as merchandise, production supplies, work in process, and finished goods.
4. 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. Illustration 5-34 shows a maturity analysis for Cadbury plc (GBR).

ILLUSTRATION 5-34
Maturity Analysis for Receivables

Another maturity analysis is required for financial liabilities. Illustration 5-35 shows such an analysis for Christian Dior (FRA).

ILLUSTRATION 5-35
Maturity Analysis for Financial Liabilities

Also, companies are required to reconcile the balances for many of the assets and liabilities reported in the financial statements from the beginning to the end of the year. For example, a reconciliation of the balances in property, plant, and equipment; intangible assets; and provisions are generally provided. An example for property, plant, and equipment for Nestlé (CHE) is shown in Illustration 5-36.

ILLUSTRATION 5-36
Reconciliation Schedule for Property, Plant, and Equipment

Note disclosure is extensive using IFRS. Many companies' annual reports are substantial in nature, and it is not unusual for a large company to have over 20 pages of notes to the financial statements.

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, companies may use parenthetical explanations and cross-reference and contra items.

Parenthetical Explanations

Companies often provide additional information by parenthetical explanations following the item. For example, Illustration 5-37 shows a parenthetical explanation of the number of shares issued by Cadbury plc (GBR) on the statement of financial position under “Equity.”

ILLUSTRATION 5-37
Parenthetical Disclosure of Shares Issued

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 into the body of the statement where readers will less likely overlook 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 Illustration 5-38, on December 31, 2015, a company might show the following entries—one listed among the current assets, and the other listed among the current liabilities.

ILLUSTRATION 5-38
Cross-Referencing and Contra Items

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 either 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 either 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, IAS No. 1 also addresses important issues related to presentation. [9]

Offsetting

IAS No. 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.

Consistency

The Conceptual Framework discussed in Chapter 2 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. [10] 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 Framework. It is presumed that the use of IFRS with appropriate disclosure results in financial statements that are fairly presented. In other words, inappropriate use of accounting policies cannot be overcome by explanatory notes to the financial statements.

In some rare cases, as indicated in Chapter 2, companies can use a “true and fair” override. 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. As indicated earlier, a true and fair override is highly unlikely in today's reporting environment.⁹

KEY TERMS

account form, 194

accounting policies, 204

accumulated other comprehensive income, 191

adjunct account, 208

balance sheet, 182

cash debt coverage, 203

comparative information, 204

contra account, 208

current assets, 187

current cash debt coverage, 202

current liabilities, 193

equity (shareholders), 184, 191

financial flexibility, 182

financial instrument, 186 (n)

financing activities, 197

free cash flow, 203

held-for-collection securities, 185

intangible assets, 186

investing activities, 197

liquidity, 182

long-term investments, 185

non-controlling interest (minority interest), 191

non-current assets, 184

non-current liabilities, 192

non-trading equity securities, 185

operating activities, 197

property, plant, and equipment, 185

report form, 194

retained earnings, 191

share capital, 191

share premium, 191

solvency, 182

statement of cash flows, 196

statement of financial position, 182

trading securities, 185

treasury shares, 191

working capital, 194

Explain the uses and limitations of a statement of financial position. The statement of financial position provides information about the nature and amounts of investments in a company's resources, obligations to creditors, and equity. The statement of financial position contributes to financial reporting by providing a basis for (1) computing rates of return, (2) evaluating the capital structure of the enterprise, and (3) assessing the liquidity, solvency, and financial flexibility of the enterprise.

Three limitations of a statement of financial position are as follows. (1) The statement of financial position generally does not reflect fair value because accountants use a historical cost basis in valuing and reporting most assets and liabilities. (2) Companies must use judgments and estimates to determine certain amounts, such as the collectibility of receivables and the useful life of long-term tangible and intangible assets. (3) The statement of financial position omits many items that are of financial value to the business but cannot be recorded objectively, such as human resources, customer base, and reputation.

Identify the major classifications of the statement of financial position. The general elements of the statement of financial position are assets, equity, and liabilities. The major classifications of assets are non-current assets; long-term investments; property, plant, and equipment; intangible assets; other assets; and current assets. The major classifications of liabilities are non-current and current liabilities. The statement of financial position of a corporation generally classifies equity as share capital, share premium, and retained earnings.

Prepare a classified statement of financial position using the report and account formats. The report form lists equity and liabilities directly below assets on the same page. The account form lists assets, by sections, on the left side, and equity and liabilities, by sections, on the right side.

Indicate the purpose of the statement of cash flows. The primary purpose of a statement of cash flows is to provide relevant information about a company's cash receipts and cash payments during a period. Reporting the sources, uses, and net change in cash enables financial statement readers to know what is happening to a company's most liquid resource.

Identify the content of the statement of cash flows. In the statement of cash flows, companies classify the period's cash receipts and cash payments into three different activities. (1) Operating activities: Involve the cash effects of transactions that enter into the determination of net income. (2) Investing activities: Include making and collecting loans, and acquiring and disposing of investments (both debt and equity) and of property, plant, and equipment. (3) Financing activities: Involve liability and equity items. Financing activities include (a) obtaining capital from owners and providing them with a return on their investment, and (b) borrowing money from creditors and repaying the amounts borrowed.

Prepare a basic statement of cash flows. The information to prepare the statement of cash flows usually comes from comparative statements of financial position, the current income statement, and selected transaction data. Companies follow four steps to prepare the statement of cash flows from these sources. (1) Determine the net cash provided by (or used in) operating activities. (2) Determine the net cash provided by (or used in) investing and financing activities. (3) Determine the change (increase or decrease) in cash during the period. (4) Reconcile the change in cash with the beginning and ending cash balances.

Understand the usefulness of the statement of cash flows. Creditors examine the cash flow statement carefully because they are concerned about being paid. The net cash flow provided by operating activities in relation to the company's liabilities is helpful in making this assessment. Two ratios used in this regard are the current cash debt coverage and the cash debt coverage. In addition, the amount of free cash flow provides creditors and shareholders with a picture of the company's financial flexibility.

Determine additional information requiring note disclosure. In addition to a complete set of financial statements, IFRS also requires additional reporting in the notes to the financial statements. Disclosure in the notes includes (1) accounting policies and (2) expanded disclosures and detailed schedules related to such items as property, plant, and equipment; receivables; liabilities and provisions; and equity.

Describe the major disclosure techniques for the statement of financial position. Companies use two methods to disclose pertinent information in the statement of financial position. (1) Parenthetical explanations: Parenthetical information provides additional information or description following the item. (2) Cross-reference and contra items: Companies “cross-reference” a direct relationship between an asset and a liability on the statement of financial position. IFRS also provides guidelines related to offsetting amounts (generally not permitted), consistency in application of accounting policies, and “true and fair” presentation.

APPENDIX 5A RATIO ANALYSIS—A REFERENCE

USING RATIOS TO ANALYZE PERFORMANCE

Analysts and other interested parties can gather qualitative information from financial statements by examining relationships between items on the statements and identifying trends in these relationships. A useful starting point in developing this information is ratio analysis.

A ratio expresses the mathematical relationship between one quantity and another. Ratio analysis expresses the relationship among pieces of selected financial statement data, in a percentage, a rate, or a simple proportion.

To illustrate, Acer Group (TWN) recently had current assets of NT$186,391 million and current liabilities of NT$149,315 million. We find the ratio between these two amounts by dividing current assets by current liabilities. The alternative means of expression are:

Percentage:	Current assets are 125% of current liabilities.
Rate:	Current assets are 1.25 times as great as current liabilities.
Proportion:	The relationship of current assets to current liabilities is 1.25:1.

To analyze financial statements, we classify ratios into four types, as follows.

In Chapter 5, we discussed three measures related to the statement of cash flows (current cash debt coverage, cash debt coverage, and free cash flow). Throughout the remainder of the textbook, we provide ratios to help you understand and interpret the information presented in financial statements. Illustration 5A-1 presents the ratios that we will use throughout the textbook. You should find this chart helpful as you examine these ratios in more detail in the following chapters. An appendix to Chapter 24 further discusses financial statement analysis.

ILLUSTRATION 5A-1
A Summary of Financial Ratios

KEY TERMS

activity ratios, 213

coverage ratios, 213

liquidity ratios, 213

profitability ratios, 213

ratio analysis, 213

Identify the major types of financial ratios and what they measure. Ratios express the mathematical relationship between one quantity and another, expressed as a percentage, a rate, or a proportion. Liquidity ratios measure the short-term ability to pay maturing obligations. Activity ratios measure the effectiveness of asset usage. Profitability ratios measure the success or failure of an enterprise. Coverage ratios measure the degree of protection for long-term creditors and investors.

1. How does information from the statement of financial position help users of the financial statements?
2. What is meant by solvency? What information in the statement of financial position can be used to assess a company's solvency?
3. A financial magazine indicated that the airline industry has poor financial flexibility. What is meant by financial flexibility, and why is it important?
4. Discuss at least two situations in which estimates could affect the usefulness of information in the statement of financial position.
5. Perez Company reported an increase in inventories in the past year. Discuss the effect of this change on the current ratio (current assets ÷ current liabilities). What does this tell a statement user about Perez Company's liquidity?
6. What is meant by liquidity? Rank the following assets from one to five in order of liquidity.
   1. (a) Goodwill.
   2. (b) Inventory.
   3. (c) Buildings.
   4. (d) Short-term investments.
   5. (e) Accounts receivable.
7. What are the major limitations of the statement of financial position as a source of information?
8. Discuss at least two items that are important to the value of companies like Louis Vuitton (LVMH Group) (FRA) or adidas (DEU) but that are not recorded in their statements of financial position. What are some reasons why these items are not recorded in the statement of financial position?
9. How does separating current assets from property, plant, and equipment in the statement of financial position help analysts?
10. In its December 31, 2015, statement of financial position, Oakley Corporation reported as an asset, “Net notes and accounts receivable, €7,100,000.” What other disclosures are necessary?
11. Should non-trading equity securities always be reported as a current asset? Explain.
12. What is the relationship between current assets and current liabilities?
13. Manchester United, Inc. sold 10,000 season tickets at £2,000 each. By December 31, 2015, 8 of the 20 home games had been played. What amount should be reported as a current liability at December 31, 2015?
14. What is working capital? How does working capital relate to the operating cycle?
15. In what section of the statement of financial position should the following items appear, and what statement of financial position terminology would you use?
    1. (a) Treasury shares (recorded at cost).
    2. (b) Checking account at bank.
    3. (c) Land (held as an investment).
    4. (d) Sinking fund.
    5. (e) Provision for warranties (short-term).
    6. (f) Copyrights.
    7. (g) Pension fund assets.
    8. (h) Share capital—ordinary.
    9. (i) Long-term investments (pledged against bank loans payable).
    10. (j) Non-controlling interest (minority interest).
16. Where should the following items be shown on the statement of financial position, if shown at all?
    1. (a) Allowance for doubtful accounts.
    2. (b) Merchandise held on consignment.
    3. (c) Advances received on sales contract.
    4. (d) Accumulated other comprehensive income.
    5. (e) Land.
    6. (f) Merchandise out on consignment.
    7. (g) Franchises.
    8. (h) Accumulated depreciation of plant and equipment.
    9. (i) Materials in transit—purchased f.o.b. destination.
17. State the usual basis of valuation of each of the following assets.
    1. (a) Trade accounts receivable.
    2. (b) Land.
    3. (c) Inventory.
    4. (d) Trading securities (ordinary shares of other companies).
    5. (e) Prepaid expenses.
18. Refer to the definition of assets on page 184. Discuss how a leased building might qualify as an asset of the lessee (tenant) under this definition.
19. Kathleen Battle says, “Retained earnings should be reported as an asset, since it is earnings which are reinvested in the business.” How would you respond to Battle?
20. The creditors of Chan Ho Company agree to accept promissory notes for the amount of its indebtedness with a condition that two-thirds of the annual profits must be applied to their liquidation. How should these notes be reported on the statement of financial position of the issuing company? Give a reason for your answer.
21. What is the purpose of a statement of cash flows? How does it differ from a statement of financial position and a statement of comprehensive income?
22. The net income for the year for Genesis, Inc. is £750,000, but the statement of cash flows reports that net cash provided by operating activities is £640,000. What might account for the difference?
23. Net income for the year for Carrie, Inc. was $750,000, but the statement of cash flows reports that net cash provided by operating activities was $860,000. What might account for the difference?
24. Differentiate between operating activities, investing activities, and financing activities.
25. Each of the following items must be considered in preparing a statement of cash flows. Indicate where each item is to be reported in the statement, if at all. Assume that net income is reported as ¥90,000 (amounts in thousands).
    1. (a) Accounts receivable increased from ¥34,000 to ¥39,000 from the beginning to the end of the year.
    2. (b) During the year, 10,000 ordinary shares with a par value of ¥100 per share were issued at ¥115 per share.
    3. (c) Depreciation expense amounted to ¥14,000, and intangible asset amortization amounted to ¥5,000.
    4. (d) Land increased from ¥10,000 to ¥30,000 due to purchase through issuance of long-term debt.
26. Sergey Co. has net cash provided by operating activities of €1,200,000. Its average current liabilities for the period are €1,000,000, and its average total liabilities are €1,500,000. Comment on the company's liquidity and financial flexibility given this information.
27. Net income for the year for Tanizaki, Inc. was $750,000, but the statement of cash flows reports that net cash provided by operating activities was $860,000. Tanizaki also reported capital expenditures of $75,000 and paid dividends in the amount of $30,000. Compute Tanizaki's free cash flow.
28. What is the purpose of a free cash flow analysis?
29. What is a “Summary of Significant Accounting Policies”?
30. What are some of the techniques of disclosure for financial statement information?
31. Briefly describe some of the similarities and differences between IFRS and U.S. GAAP with respect to statement of financial position reporting.
32. Briefly describe the convergence efforts related to financial statement presentation.
33. Rainmaker Company prepares its financial statements in accordance with U.S. GAAP. Briefly discuss the differences in order of presentation in its statement of financial position compared to IFRS.

BE5-1 Harding Corporation has the following accounts included in its December 31, 2015, trial balance: Accounts Receivable €110,000, Inventory €290,000, Allowance for Doubtful Accounts €8,000, Patents €72,000, Prepaid Insurance €9,500, Accounts Payable €77,000, and Cash €30,000. Prepare the current assets section of the statement of financial position, listing the accounts in the sequence shown in the chapter.

BE5-2 Koch Corporation's adjusted trial balance contained the following asset accounts at December 31, 2015: Cash €7,000, Land €40,000, Patents €12,500, Accounts Receivable €90,000, Prepaid Insurance €5,200, Inventory €30,000, Allowance for Doubtful Accounts €4,000, and Trading Securities €11,000. Prepare the current assets section of the statement of financial position, listing the accounts in the sequence shown in the chapter.

BE5-3 Included in Outkast Company's December 31, 2015, trial balance are the following accounts: Prepaid Rent $5,200, Held-for-Collection Securities $56,000, Unearned Service Revenue $17,000, Land Held for Investment $39,000, and Notes Receivable (long-term) $42,000. Prepare the long-term investments section of the statement of financial position.

BE5-4 Lowell Company's December 31, 2015, trial balance includes the following accounts: Inventory $120,000, Buildings $207,000, Accumulated Depreciation–Equipment $19,000, Equipment $190,000, Land Held for Investment $46,000, Accumulated Depreciation–Buildings $45,000, and Land $71,000. Prepare the property, plant, and equipment section of the statement of financial position.

BE5-5 Crane Corporation has the following accounts included in its December 31, 2015, trial balance: Trading Securities £21,000, Goodwill £150,000, Prepaid Insurance £12,000, Patents £220,000, and Franchises £130,000. Prepare the intangible assets section of the statement of financial position.

BE5-6 Patrick Corporation's adjusted trial balance contained the following asset accounts at December 31, 2015: Capitalized Development Costs $18,000, Prepaid Rent $12,000, Goodwill $50,000, Franchise Fees Receivable $2,000, Franchises $47,000, Patents $33,000, and Trademarks $10,000. Prepare the intangible assets section of the statement of financial position.

BE5-7 Thomas Corporation's adjusted trial balance contained the following liability accounts at December 31, 2015. Bonds Payable (due in 3 years) $100,000, Accounts Payable $72,000, Notes Payable (due in 90 days) $22,500, Salaries and Wages Payable $4,000, and Income Taxes Payable $7,000. Prepare the current liabilities section of the statement of financial position.

BE5-8 Included in Arco Company's December 31, 2015, trial balance are the following accounts: Accounts Payable 220,000, Pension Liability 375,000, Advances from Customers 41,000, Bonds Payable 371,000, Salaries and Wages Payable 27,000, Interest Payable 12,000, Income Taxes Payable 29,000, and Provision for Warranties (current 3,000, non-current 6,000). Prepare the current liabilities section of the statement of financial position.

BE5-9 Use the information presented in BE5-8 for Arco Company to prepare the non-current liabilities section of the statement of financial position.

BE5-10 Hawthorn Corporation's adjusted trial balance contained the following accounts at December 31, 2015: Retained Earnings €120,000, Share Capital—Ordinary €750,000, Bonds Payable €100,000, Share Premium—Ordinary €200,000, Goodwill €55,000, Accumulated Other Comprehensive Income €(150,000), and Non-Controlling Interest €80,000. Prepare the equity section of the statement of financial position.

BE5-11 Stowe Company's December 31, 2015, trial balance includes the following accounts: Share Capital—Ordinary €70,000, Retained Earnings €114,000, Trademarks €31,000, Share Capital—Preference €152,000, Trading Securities €55,000, Deferred Income Taxes €88,000, Share Premium—Ordinary €174,000, and Non-Controlling Interest €18,000. Prepare the equity section of the statement of financial position.

E5-1 (Statement of Financial Position Classifications) Presented below are a number of statement of financial position accounts of Cunningham, Inc.

1. (a) Investment in Preference Shares.
2. (b) Treasury Shares.
3. (c) Share Capital—Ordinary.
4. (d) Dividends Payable.
5. (e) Accumulated Depreciation—Equipment
6. (f) Construction in Process.
7. (g) Petty Cash.
8. (h) Interest Payable.
9. (i) Deficit.
10. (j) Trading Securities.
11. (k) Income Taxes Payable.
12. (l) Unearned Service Revenue.
13. (m) Work in Process.
14. (n) Salaries and Wages Payable.

E5-2 (Classification of Statement of Financial Position Accounts) Presented below are the captions of Nikos Company's statement of financial position.

1. (a) Non-current assets.
   1. (1) Investments.
   2. (2) Property, plant, and equipment.
   3. (3) Intangible assets.
   4. (4) Other assets.
2. (b) Current assets.
3. (c) Equity.
4. (d) Non-current liabilities.
5. (e) Current liabilities.

E5-3 (Classification of Statement of Financial Position Accounts) Assume that Masters Enterprises uses the following headings on its statement of financial position.

1. (a) Investments.
2. (b) Property, plant, and equipment.
3. (c) Intangible assets.
4. (d) Other assets.
5. (e) Current assets.
6. (f) Non-current liabilities.
7. (g) Current liabilities.
8. (h) Share capital.
9. (i) Share premium.
10. (j) Retained earnings.
11. (k) Accumulated other comprehensive income.

E5-4 (Preparation of a Classified Statement of Financial Position) Assume that Gulistan Inc. has the following accounts at the end of the current year.

E5-9 (Current Assets and Current Liabilities) The current assets and current liabilities sections of the statement of financial position of Jin Liu Company appear as follows (amounts in thousands).

E5-15 (Preparation of a Statement of Cash Flows) Presented below is a condensed version of the comparative statements of financial position for Yoon Corporation for the last two years at December 31 (amounts in millions).

E5-16 (Preparation of a Statement of Cash Flows) A comparative statement of financial position for Orozco Corporation is presented below.

E5-17 (Preparation of a Statement of Cash Flows and a Statement of Financial Position) Chekov Corporation's statement of financial position at the end of 2014 included the following items.

E5-18 (Preparation of a Statement of Cash Flows, Analysis) The comparative statements of financial position of Menachem Corporation at the beginning and end of the year 2015 appear below.

P5-6 (Preparation of a Statement of Cash Flows and a Statement of Financial Position) Lansbury Inc. had the statement of financial position shown below at December 31, 2014.

P5-7 (Preparation of a Statement of Cash Flows and Statement of Financial Position) Luo Inc. had the following statement of financial position at December 31, 2014 (amounts in thousands).

CA5-1 (Reporting the Financial Effects of Varied Transactions) In an examination of Arenes Corporation as of December 31, 2015, you have learned that the following situations exist. No entries have been made in the accounting records for these items.

1. The corporation erected its present factory building in 2000. Depreciation was calculated by the straight-line method, using an estimated life of 35 years. Early in 2015, the board of directors conducted a careful survey and estimated that the factory building had a remaining useful life of 25 years as of January 1, 2015.
2. When calculating the accrual for officers' salaries at December 31, 2015, it was discovered that the accrual for officers' salaries for December 31, 2014, had been overstated.
3. On December 15, 2015, Arenes Corporation declared a cash dividend on its ordinary shares outstanding, payable February 1, 2016, to the shareholders of record December 31, 2015.

Instructions

Describe fully how each of the items above should be reported in the financial statements of Arenes Corporation for the year 2015.

CA5-2 (Current Asset and Liability Classification) Below are the titles of a number of debit and credit accounts as they might appear on the statement of financial position of Hayduke Corporation as of October 31, 2015.

Instructions

Select the current asset and current liability items from among these debit and credit accounts. If there appear to be certain borderline cases that you are unable to classify without further information, mention them and explain your difficulty, or give your reasons for making questionable classifications, if any.

CA5-3 (Identifying Statement of Financial Position Deficiencies) The assets of Fonzarelli Corporation are presented on the next page (amounts in thousands).

CA5-4 (Critique of Statement of Financial Position Format and Content) The following is the statement of financial position of Rasheed Brothers Corporation (amounts in thousands).

CA5-5 (Presentation of Property, Plant, and Equipment) Carol Keene, corporate comptroller for Dumaine Industries, is trying to decide how to present “Property, plant, and equipment” in the statement of financial position. She realizes that the statement of cash flows will show that the company made a significant investment in purchasing new equipment this year, but overall she knows the company's plant assets are rather old. She feels that she can disclose one figure titled “Property, plant, and equipment, net of depreciation,” and the result will be a low figure. However, it will not disclose the age of the assets. If she chooses to show the cost less accumulated depreciation, the age of the assets will be apparent. She proposes the following.

CA5-6 (Cash Flow Analysis) The partner in charge of the Kappeler Corporation audit comes by your desk and leaves a letter he has started to the CEO and a copy of the cash flow statement for the year ended December 31, 2015. Because he must leave on an emergency, he asks you to finish the letter by explaining (1) the disparity between net income and cash flow, (2) the importance of operating cash flow, (3) the renewable source(s) of cash flow, and (4) possible suggestions to improve the cash position.