ACCOUNTING

THEORY:
TEXT AND READINGS
RICHARD G. SCHROEDER
MYRTLE CLARK
JACK CATHEY

CHAPTER 7
FINANCIAL STATEMENTS II:

e
c
n
a
l
Ba
Sheet

State
ment
of Ca
sh
Flows

Introduction
Financial reports can be divided into two
categories

1.

Results of the flows of resources over time (flows)

2.

The status of resources at a point in time (stocks)

Statement
Statement
of
Income
o
f
Retained
t
n
e
Statem
Cash
Earnings
Flows

Balance
Sheet

Past Emphasis

Income statement

based on the assumption that flows

were more important than stocks

Frequently resulted in the

measurement of stocks at
residual values

FASB

asset - liability approach

changes in balance sheet amounts becoming
more important in income determination

In this chapter
Balance sheet and the associated measurement
techniques for its elements
Statement of cash flows and its evolution over time

e
c
n
a
l
Ba
Sheet

State
ment
of Ca
sh
Flows

The Balance Sheet

Should disclose wealth of a company at a point in

time

Wealth is present value of all

resources
obligations

The Balance Sheet

This measurement technique is limited

Consequently, a variety of measurement techniques are
used to measure the elements of the balance sheet
Historical (Historical cost)
Current oriented (Current value)
Future oriented (Expected realizable value)

Balance Sheet
Elements
The elements of the balance sheet were defined in SFAC No. 6 as:
Assets
Liabilities
Equity

Definitions arise from the FASBs asset - liability approach to

income determination
Departure from previous definitions that resulted in valuations
arrived at via the residual effect of income determination

Components of the Balance

Sheet
Assets
Current assets
Investments
Property, plant, and equipment
Intangible assets
Other assets

Liabilities
Current liabilities
Long-term debt
Other liabilities

Stockholders Equity
Capital stock
Additional paid-in capital
Retained earnings

Asset Valuation
Asset

Measurement basis

Cash

Current value

Accounts receivable

Expected future value

Marketable securities

Fair value

Inventory

Current or past value

Investments

Fair value or amortized cost

Property, plant and equipment

Depreciated past value

Liabilities and Their

Associated Measurement
Techniques
Liability
Current Liabilities
Long-term &
Other Liabilities

Measurement
Liquidation Value
Liquidation Value
or Present Value

Do measurement techniques
bias statements in favor of
current investors?

Stockholders Equity Accounts

and Their Associated
Measurement Techniques
Account

Measurement basis

Common Stock

Historical Cost
(Par Value vs Selling Price)

Preferred Stock

Historical Cost

Retained Earnings
& Other
Comprehensive
Income

Dependent upon income

Recognition

Fair Value Measurements under

SFAS No. 157

New definition for fair value

Hierarchy for sources of information
New disclosures of assets and liabilities
Modification of presumption of transaction
price

Proposed Statement of Financial

Position

FASB-IASB Project (Phase B)

Groups assets and liabilities together

Operating
Investing
Financing

Provides separate section

for stockholders equity

Asset
s
Liabil &
ities
Opera
ti
Inves ng
ti
Finan ng
cing
Stock
holde
Equit rs
y

Evaluating A Companys
Financial Position
Return on Assets
Net operating profit after taxes
Average total assets
Profit margin
Net operating profit after taxes
Net sales
Asset utilization rate
Net sales
Average total assets

Hershey & Tootsie Ratios for

2005
Return on assets
Profit margin
Asset turnover

Hershey
15.31%
12.83%
1.19

Tootsie
9.5870%
15.9770%
0.60

Hershey and Tootsie: Return on

Assets

Evolution of the Statement

of Cash Flows

Prior to 1971

Firms were preparing funds

statements
No guidelines - Methods of preparing statement:
1
2
3

only two required

financial statements

Cash
Working capital
All financial resources

APB No. 3 - recommended

APB No. 19 - mandatory - all financial resources

APB Opinions 3 and

19

Designed to answer the following questions

Where did the profits go?

Why werent dividends larger?
How was it possible to distribute dividends
in the presence of a loss?
Why are current assets down when there was a profit?
Why is extra financing required?
How was the expansion financed?
Where did the funds from the sale of securities go?
How was the debt retirement accomplished?
How was the increase in working capital financed?

2
3

4
5
6
7
8
9

Cash Flow
Information

Should enable financial statement

users to

Predict the amount of cash that is likely to be

distributed as dividends or interest
Evaluate risk

Presentation of cash flow information assists in

evaluating

Liquidity

Solvency

nearness to cash
going concern

Financial flexibility

react to crisis

Historical
Perspective
Discussion memorandum

Reporting Funds Flows, Liquidity, and Financial Flexibility

preceded the issuance of SFAS No. 95

Questions raised in this DM included:

1. Which concept of funds should be adopted?
2. How should transactions not having a direct impact on funds be
reported?
3. Which of the various approaches should be used for presenting
funds flow information?
4. How should information about funds flow from operations be
presented?
5. Should funds flow information be separated into outflows for
(a) maintenance
(b) expansion of operating capacity, and
(c) nonoperating purposes

Historical
Perspective

Exposure Draft

Reporting Income, Cash Flows and Financial

Position of Business Enterprises

SFAC No. 5

Recognition and
Measurement in Financial
Statements of Business
Enterprises

Purpose of the
Statement of Cash Flows

Provide relevant information about

cash receipts and cash payments of
an enterprise

Objectives of accounting discussed in SFAC

Nos. 1 and 5 led to conclusion

Statement of cash flows should replace the

previously required statement of changes in
financial position

Statement Format

Report changes during an accounting

period in cash and cash equivalents for

Net cash flows from operations

Investing transactions
Financing transactions

Cash Flows From Operating

Activities

Cash effect from transactions

that enter into the determination
of net income

exclusive of financing and investing activities

Direct vs Indirect method

Cash Flows From Investing

Activities

Making and collecting loans

Acquiring and disposing of debt
or equity securities of other companies
Acquiring and disposing of property, plant,
and equipment and other productive
resources

Cash Flows From Financing

Activities
Results from

Obtaining resources from owners

Providing owners with a return
of and a return on their investment
Borrowing money and repaying
the amount borrowed
Obtaining and paying for other resources
from long-term creditors

Proposed Statement of Cash

Flows
Propo
s
State ed
ment
of
Cash
Flows

Phase B of FASB-IASB Presentation Project

Expanded version of direct method
Additional disclosures for each category

Uses of Cash Flow

Information

A major objective of accounting

to provide data allowing the presentation of cash

flows to investors and creditors
to allow evaluation of risk

Net income is not directly

associated with cash
Investors expect return equal to
market rate of interest for investments with
equal risk

discounted
discounted future
future cash
cash flows
flows >> investment
investment

Uses of Cash Flow

Information

Past cash flows are the best indicators of future cash

flows
Empirical research indicates cash flow information

has an incremental value over earnings

and is superior to disclosure of changes in working capital

Uses of Cash Flow

Information

Net cash provided (used) from operating activities

- Net cash provided (used) from investing activities

Free Cash Flow

Uses of Cash Flow

Information

Uses of Cash Flow

Information
These

results indicate

Hershey experienced
deteriorating free cash flow
positions during fiscal year
2005
Tootsies position improved

International Accounting
Standards

The IASC has discussed:

The statement of financial position

and the various measurement bases used in accounting
Defined assets, liabilities and equity in Framework for the
Preparation and Presentation of Financial Statements

2
3

The information to be disclosed on the balance sheet

and statement of cash flows in a revised IAS No. 1
The presentation of the statement of cash flows in IAS
No. 7, Cash Flow Statements

Preparation and
Presentation of Financial
Economic decisions made by users require an evaluation of the ability of
Statements
an enterprise
to generate cash
Financial position of an enterprise is affected by its
financial structure
liquidity and solvency
capacity to adapt to change (financial flexibility)
Measurement bases include
historical cost (most common)
current cost
realizable value
present value
Definitions of assets, liabilities and equity are similar to
U. S. GAAP

IAS No. 1: Presentation

of Financial Statements

Recommends disclosures similar

to U. S. GAAP
Revised IAS No. 1

requires assets to be classified as current and noncurrent

recognizes that there are differences in the nature and function of

assets, liabilities, and equity

unless a liquidity presentation provides more relevant and reliable

information

so fundamental that they should be presented on the face of the

balance sheet.

Specifies specific categories of items to be disclosed

IAS No. 7

The required presentation of the statement

of cash flows is very similar to U. S.
GAAP
Operating, financing and investing
activities are to be disclosed
Indirect or direct method of disclosing
operating activities may be used

stated a preference for the direct method.

FASB staff reaction

Prepared by
Richard Schroeder, PhD
Kathryn Yarbrough, MBA
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