Financial Statement, Statement of Cash Flow, and Time Value of Money

Chelsea Kasim (2113030)

Valencia Chandra Gunawan, Go (2113032)

Arline Cornelia L. David L. (2113045)

Atma Jaya Makassar University

Abstract

The purpose of this article is to analyze the effect of the time value of
money on the financial statement. The article also includes discussions on income
statement, retained earnings, statement of financial position, cash flow statement,
and time value of money. Keyword: financial statement, balance sheet, statement
of cash flow, time value of money, present value, future value.

1. Introduction
The income statement is the report that measures the success of company
operations for a given period of time. Income statement will evaluate the past
performance of a company, provide a basis for predicting future performance,
and help assess the risk or uncertainty of achieving future cash flow. Several
limitations of the income statements, such as items omitation that can’t be
measured reliably, affect of accounting methos employed, and judgment has
the possibility of reducing the usefulness of information provided by the
income statement for predicting amounts, timing, and uncertainty of future
cash flows. Intermediate components of the income statement include
operating section, non-operating section, income tax, discontinued operations,
noncontrolling interest, and earnings per share.

Electronic copy available at: https://ssrn.com/abstract=4338250

 Balance sheet (statement of financial position) reports the assets,
liabilities, and equities of a business enterprise at a specific date. By reporting
information on assets, liabilities, and stockholders’ equity, the balance sheet
provides a basis for computing rates of return and evaluating the capital
structure of the enterprise. Analysts also use information in the balance sheet
to assess a company’s risk and future cash flow. In this regard, analysts use
the balance sheet to assess a company’s liquidity, solvency, and financial
flexibility.
Time value of money plays an important role in long-term decision
making. In accounting and finance, the phrase time value of money indicates
the relationship between time and money-that money received today is more
valuable than money promised at some time in the future. This is due to the
opportunity to invest money today and receive interest on the investment.
However, when deciding between investment or borrowing alternatives, it is
important to be able to have today's money and tomorrow's money.

2. Literature Review
2.1. Income Statement & Retained Earnings
Income statement measures the success of company operations for a
given period of time. It is also often called the statement of income or
statement of earnings. Usefulness of the Income Statement:
 Evaluate the past performance of the company.
 Provide a basis for predicting future performance.
 Help assess the risk or uncertainty of achieving future cash flows.
Limitations of the Income Statement:
● Companies omit items from the income statement that they cannot
measure reliably.
● Income numbers are affected by the accounting methods employed.
● Income measurement involves judgment.

Electronic copy available at: https://ssrn.com/abstract=4338250

Quality of Earnings
Earning management is often defined as the planned timing of revenues,
expenses, gains, and losses to smooth out bumps in earnings. Such earnings
management negatively affects the quality of earnings if it distorts the
information in a way that is less useful for predicting future earnings and cash
flows. Elements of the Income Statement:
 Revenues. Inflows or other enhancements of assets of an entity or
settlements of its liabilities during a period from delivering or producing
goods, rendering services, or other activities that constitute the entity’s
ongoing major or central operations.
 Expenses. Outflows or other using-up of assets or incurrences of
liabilities during a period from delivering or producing goods, rendering
services, or carrying out other activities that constitute the entity’s
ongoing major or central operations.
 Gains. Increases in equity (net assets) from peripheral or incidental
transactions of an entity except those that result from revenues or
investments by owners.
 Losses. Decreases in equity (net assets) from peripheral or incidental
transactions of an entity except those that result from expenses or
distributions to owners.
Types of Income Statement:
 Intermediate. Companies present nonoperating revenues, gains, expenses,
and losses in a separate section, before income taxes and income from
operations.
 Condensed. Includes only the totals of expense groups in the statement of
income. It then also prepares supplementary schedules to support the
totals.
 Single-Step. Two groupings: revenues and expenses. Expenses are
deducted from revenues to arrive at net income or loss, hence the
expression “single-step.”

Electronic copy available at: https://ssrn.com/abstract=4338250

Reporting Various Income Items
As a result, the accounting profession has adopted a modified all-
inclusive concept. In this approach, companies record most items, including
unusual or infrequent ones, as part of net income. In addition, companies are
required to highlight these items in the financial statements so that users can
better determine the long-run earning power of the company. These income
items fall into four general categories, which we discuss in the following
sections: Unusual and infrequent gains and losses, discontinued operations,
non-controlling interest, earnings per share.
Changes in Accounting Principle
Changes in accounting principle include a change in the method of
inventory pricing from FIFO to average-cost, or a change in accounting for
construction contracts from the percentage-of-completion to the completed-
contract method.
Changes in Accounting Estimates
Changes in accounting estimates are inherent in the accounting process.
For example, companies estimate useful lives and salvage values of
depreciable assets, uncollectible receivables, inventory obsolescence, and the
number of periods expected to benefit from a particular expenditure. Not
infrequently, due to time, circumstances, or new information, even estimates
originally made in good faith must be changed. A company accounts for such
changes in estimates in the period of change if they affect only that period, or
in the period of change and future periods if the change affects both.
Corrections of Errors
Companies correct errors by making proper entries in the accounts and
reporting the corrections in the financial statements. Corrections of errors are
treated as prior period adjustments, similar to changes in accounting
principles. Companies record a correction of an error in the year in which it is
discovered.

Electronic copy available at: https://ssrn.com/abstract=4338250

 They report the error in the financial statements as an adjustment to the
beginning balance of retained earnings. If a company prepares comparative
financial statements, it should restate the prior statements for the effects of the
error.
Restrictions of Retained Earnings
The retained earnings section may therefore report two separate
amounts—(1) retained earnings free (unrestricted) and (2) retained earnings
appropriated (restricted).
Comprehensive Income
Comprehensive income includes all changes in equity during a period
except those resulting from investments by owners and distributions to
owners. Comprehensive income, therefore, includes the following: all
revenues and gains, expenses and losses reported in net income, and all gains
and losses that bypass net income but affect stockholders’ equity. These items
non-owner changes in equity that bypass the income statement—are referred
to as other comprehensive income. Companies must display the components
of other comprehensive income in one of two ways:
 A single continuous statement (one statement approach), or
 Two separate, but consecutive statements of net income and other
comprehensive income (two statement approach).
2.2. Balance Sheet and Statement of Cash Flows
Balance Sheet
The balance sheet, sometimes referred to as the statement of fi nancial
position, reports the assets, liabilities, and stockholders’ equity of a business
enterprise at a specific date. Balance sheet accounts are classified. That is, the
balance sheet groups items that are similar in order to arrive at significant
subtotals. Companies must report and classify individual items in sufficient
detail to enable users to assess the amount, timing, and uncertainty of future
cash flows, and the uncertainty of future cash flows. The classification also
allows users to evaluate the company's liquidity, financial flexibility,
profitability, and risk.

Electronic copy available at: https://ssrn.com/abstract=4338250

 To classify items in the financial statements, companies group items that
have similar characteristics and separate items that have different
characteristics. The company must report separately:
 Assets that differ in terms of type or expected function in the company's
main operations or other activities
 Assets and liabilities with different implications for the company's
financial flexibility
 Assets and liabilities with different general liquidity characteristics.
Statement of Cash Flows
An important element of the purpose of financial reporting is to assess
the amount, timing, and uncertainty of cash flows. Three frequently used
financial statements are the income statement, the statement of shareholders'
equity, and the balance sheet, each of which provides some information about
a company's cash flows during a period. For example, the income statement
provides information about resources provided by operations but not exactly
cash. Whereas the statement of shareholders' equity shows the amount of cash
used to pay dividends or buy treasury stock. A comparative balance sheet can
show what assets have been acquired or disposed of by the company, and
what liabilities have been incurred or liquidated.
The primary objective of the statement of cash flows is to provide
relevant information about a company's cash receipts and cash payments
during a period. To achieve this objective, the statement of cash flows reports
the following:
 Cash from operating activities during the period
 Investment transactions
 Financing transactions
 Net increase or decrease in cash during the period
Reporting the sources, uses, and net increase or decrease in cash helps
investors, creditors, and others know what is happening to the company's
most liquid resource. Since most individuals keep checkbooks and prepare

Electronic copy available at: https://ssrn.com/abstract=4338250

 tax returns on a cash basis, they can understand the information reported in
the statement of cash flows.
While net income provides a long-term measure of a company's success
or failure, cash is the lifeblood of the company. Without cash, the company
will not survive. For small and emerging companies, cash flow is the single
most important element for survival. Even medium and large companies must
control cash flow.
Creditors examine cash flow statements carefully because they are
concerned about payments. They start their examination by looking for net
cash provided by operating activities. A high amount indicates that the
company is able to generate enough cash from operations to pay its bills
without further borrowing. Conversely, a low or negative amount of net cash
obtained from operating activities indicates that the company may have to
borrow or issue equity to obtain enough cash to pay its bills.
2.3. Time Value of Money
Financial reporting uses different measurements in different situations-
historical cost for equipment, net realizable value for inventories, fair value
for investments. However, for many assets and liabilities, market-based fair
value information is not readily available. In these cases, fair value can be
estimated based on the expected future cash flows related to the asset or
liability.
Present value techniques are used to convert expected cash flows into
present values, which represent an estimate of fair value. The following are
measurements of present value-based accounting: notes, leases, pensions and
other postretirement benefits, long-term assets, stock-based compensation,
business combinations, disclosures, and environmental liabilities. In addition
to accounting and business applications, compound interest, annuity, and
present value concepts apply to personal finance and investment decisions.

Electronic copy available at: https://ssrn.com/abstract=4338250

 Interest is payment for the use of money. It is the excess cash received or
repaid over and above the amount lent or borrowed (principal). The amount
of interest involved in any financing transaction is a function of three
variables: principal, interest rate, and time. Thus, the following three
relationships apply:
 The larger the principal amount, the larger the dollar amount of interest.
 The higher the interest rate, the larger the dollar amount of interest.
 The longer the time period, the larger the dollar amount of interest.
Interest divided into two: simple interest and compound interest.
Companies compute simple interest on the amount of the principal only. It is
the return on (or growth of) the principal for one time period. The following
equation expresses simple interest: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑝 × 𝑖 × 𝑛. Compound interest
is the return on (or growth of) the principal for two or more time periods.
Compounding computes interest not only on the principal but also on the
interest earned to date on that principal, assuming the interest is left on
deposit. The following equation expresses compound interest: 𝐹𝑉𝐹𝑛,𝑖 =
(1 + 𝑖)𝑛 .
Many business and investment decisions involve amounts of money that
exist now or will exist in the future. Single amount problems are generally
classified into one of the following two categories:

a. Calculating the unknown future value of a sum of money invested now

for a specified number of periods at a specified interest rate. The solution
is accumulate all cash flows to a future point. The following equation
expresses future value of single sum: 𝐹𝑉 = 𝑃𝑉(𝐹𝑉𝐹𝑛,𝑖 )
b. Computing the unknown present value of a known single sum of money
in the future that is discounted for a certain number of periods at a certain
interest rate. The solution is discount all cash flows from the future to the
present. The following equation expresses present value of single sum:
1
𝑃𝐹𝑉𝑛,𝑖 = (1+𝑖)𝑛

Electronic copy available at: https://ssrn.com/abstract=4338250

 An annuity, by definition, requires the following: (1) periodic payments
or receipts of the same amount, (2) the same-length interval between such
rents, and (3) compounding of interest once each interval. The future value of
an annuity is the sum of all the rents plus the accumulated compound interest
on them. Note that the rents may occur at either the beginning (annuity due)
or the end of the periods (ordinary annuity).
a. Future Value of Annuity
The future value of an annuity is the sum of all the rents plus the
accumulated compound interest on them.
 Future value of an ordinary annuity is calculating the value, at which
each of the rents in the series will accumulate, and then summing up
the future value of each of them. The following equation:
𝐹𝑉 𝑜𝑓 𝑎𝑛 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 = 𝑅(𝐹𝑉𝐹 − 𝑂𝐴𝑛,𝑖 )
 The annuity due assumes the periodic rent occurs at the beginning of
each period. To find the future value of the maturity annuity factor,
multiply the future value of the ordinary annuity factor by 1 plus the
interest rate (1+i).
b. Present Value of Annuity
The present value of an annuity is a single amount that, if invested with
compound interest now, would provide an annuity (a series of
withdrawals) for a number of future periods.
 The present value of an ordinary annuity is the present value of a
series of equal rents, which will be drawn at equal intervals at the
end of the period. The followinf equation:
𝑃𝑉 𝑜𝑓 𝑎𝑛 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 = 𝑅(𝑃𝑉𝐹 − 𝑂𝐴𝑛,𝑖 )
 In determining the present value of a maturity annuity, there is
always one less discount period. To find the present value of the
maturity annuity factor, multiply the present value of the ordinary
annuity factor by 1 plus the interest rate (1+i).

Electronic copy available at: https://ssrn.com/abstract=4338250

3. Conclusion and Suggestions
3.1. Conclusion

Time value of money plays an important role in long-term decisions,

including the decision to invest. If the current money will increase in value by
investing, then the company will definitely choose to invest the money now.
Therefore, time value of money is very important to estimate the value of
money in the future.

Of course, it will have an impact on the financial statement (can be seen

in fixed assets and capital accounts). With time value of money, a company
can decide whether investing in fixed assets or certain stocks can increase the
value of its money. This will be seen in the statement of financial position,
which is in the asset account and will also be seen in the income statement,
which is shown by the profit available after investing.

3.2. Suggestions

It’s better for a company to estimate the time value of money before
deciding to invest. Therefore, financial statement must show the capability of
a company to invest the money based on the income statement at the profit
after investing section. And the company should estimate the gain or loss as
the result of the investment.

10

Electronic copy available at: https://ssrn.com/abstract=4338250

 Bibliography
Donald E. Kieso, Jerry J. Weygandt, & Terry D. Warfield. (2019). Intermediate
Accounting 17e. Hoboken: Wiley.

11

Electronic copy available at: https://ssrn.com/abstract=4338250