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ACCOUNTING THEORY: TEXT AND READINGSRICHARD G. SCHROEDER MYRTLE CLARK JACK CATHEY

CHAPTER 7FINANCIAL STATEMENTS II:

IntroductionFinancial reports can be divided into two categoriesResults of the flows of resources over time (flows) The status of resources at a point in time (stocks)

Past EmphasisIncome statement based on the assumption that flows were more important than stocks Frequently resulted in the measurement of stocks at residual values

FASBasset - liability approach changes in balance sheet amounts becoming more important in income determination

In this chapterBalance sheet and the associated measurement techniques for its elementsStatement of cash flows and its evolution over time

The Balance SheetShould disclose wealth of a company at a point in time Wealth is present value of allresources obligations

The Balance SheetThis measurement technique is limitedConsequently, a variety of measurement techniques are used to measure the elements of the balance sheetHistorical (Historical cost)Current oriented (Current value)Future oriented (Expected realizable value)

Balance Sheet ElementsThe 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 determinationDeparture from previous definitions that resulted in valuations arrived at via the residual effect of income determination

Components of the Balance SheetAssetsCurrent assetsInvestmentsProperty, plant, and equipmentIntangible assetsOther assetsLiabilitiesCurrent liabilitiesLong-term debtOther liabilities Stockholders EquityCapital stockAdditional paid-in capitalRetained earnings

Asset ValuationAsset Cash Accounts receivable Marketable securitiesInventory Investments Property, plant and equipment Measurement basisCurrent valueExpected future valueFair value Current or past valueFair value or amortized costDepreciated past value

Liability Current Liabilities Long-term & Other Liabilities MeasurementLiquidation ValueLiquidation Value or Present ValueLiabilities and Their Associated Measurement Techniques Do measurement techniques bias statements in favor of current investors?

Account Common Stock Preferred Stock Retained Earnings & Other Comprehensive IncomeMeasurement basisHistorical Cost (Par Value vs Selling Price)Historical CostDependent upon income RecognitionStockholders Equity Accounts and Their Associated Measurement Techniques

Fair Value Measurements under SFAS No. 157New definition for fair valueHierarchy for sources of informationNew disclosures of assets and liabilitiesModification of presumption of transaction price

Proposed Statement of Financial PositionFASB-IASB Project (Phase B) Groups assets and liabilities togetherOperatingInvestingFinancingProvides separate section for stockholders equity

Evaluating A Companys Financial PositionReturn on AssetsNet operating profit after taxesAverage total assetsProfit marginNet operating profit after taxesNet salesAsset utilization rateNet salesAverage total assets

Hershey & Tootsie Ratios for 2005 Hershey TootsieReturn on assets 15.31% 9.5870%Profit margin 12.83% 15.9770%Asset turnover 1.19 0.60

Hershey and Tootsie: Return on Assets

Evolution of the Statement of Cash FlowsPrior to 1971only two required financial statementsFirms were preparing funds statementsNo guidelines - Methods of preparing statement:CashWorking capitalAll financial resourcesAPB No. 3 - recommendedAPB No. 19 - mandatory - all financial resources

APB Opinions 3 and 19Designed 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?

Cash Flow InformationShould enable financial statement users toPredict the amount of cash that is likely to be distributed as dividends or interestEvaluate riskPresentation of cash flow information assists in evaluatingLiquidity nearness to cashSolvency going concernFinancial flexibilityreact to crisis

Historical PerspectiveDiscussion memorandum Reporting Funds Flows, Liquidity, and Financial Flexibilitypreceded the issuance of SFAS No. 95Questions raised in this DM included:Which concept of funds should be adopted?How should transactions not having a direct impact on funds be reported?Which of the various approaches should be used for presenting funds flow information?How should information about funds flow from operations be presented?Should funds flow information be separated into outflows for maintenanceexpansion of operating capacity, andnonoperating purposes

Historical PerspectiveExposure Draft Reporting Income, Cash Flows and Financial Position of Business EnterprisesSFAC No. 5Recognition and Measurement in Financial Statements of Business Enterprises

Purpose of the Statement of Cash FlowsObjectives 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 positionProvide relevant information about cash receipts and cash payments of an enterprise

Statement FormatReport changes during an accounting period in cash and cash equivalents forNet cash flows from operationsInvesting transactionsFinancing transactions

Cash Flows From Operating ActivitiesCash effect from transactions that enter into the determination of net income exclusive of financing and investing activitiesDirect vs Indirect method

Cash Flows From Investing ActivitiesMaking and collecting loansAcquiring and disposing of debt or equity securities of other companiesAcquiring and disposing of property, plant, and equipment and other productive resources

Cash Flows From Financing ActivitiesObtaining resources from ownersProviding owners with a return of and a return on their investmentBorrowing money and repaying the amount borrowed Obtaining and paying for other resources from long-term creditorsResults from

Proposed Statement of Cash FlowsPhase B of FASB-IASB Presentation ProjectExpanded version of direct methodAdditional disclosures for each category

Uses of Cash Flow InformationA major objective of accounting to provide data allowing the presentation of cash flows to investors and creditors to allow evaluation of riskNet income is not directly associated with cashInvestors expect return equal to market rate of interest for investments with equal riskdiscounted future cash flows > investment

Uses of Cash Flow InformationPast cash flows are the best indicators of future cash flowsEmpirical 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 InformationThese results indicate Hershey experienced deteriorating free cash flow positions during fiscal year 2005Tootsies position improved

International Accounting StandardsThe IASC has discussed:The statement of financial position and the various measurement bases used in accountingDefined assets, liabilities and equity in Framework for the Preparation and Presentation of Financial StatementsThe 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 StatementsEconomic decisions made by users require an evaluation of the ability of an enterprise to generate cashFinancial position of an enterprise is affected by its financial structureliquidity and solvencycapacity to adapt to change (financial flexibility)Measurement bases include historical cost (most common)current costrealizable valuepresent valueDefinitions of assets, liabilities and equity are similar to U. S. GAAP

IAS No. 1: Presentation of Financial StatementsRecommends disclosures similar to U. S. GAAP Revised IAS No. 1 requires assets to be classified as current and noncurrent unless a liquidity presentation provides more relevant and reliable information recognizes that there are differences in the nature and function of assets, liabilities, and equity so fundamental that they should be presented on the face of the balance sheet.Specifies specific categories of items to be disclosed

IAS No. 7The required presentation of the statement of cash flows is very similar to U. S. GAAPOperating, financing and investing activities are to be disclosedIndirect or direct method of disclosing operating activities may be used stated a preference for the direct method.FASB staff reaction

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