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CHAPTER 5
Statement of Financial Position and
Statement of Cash Flows
LEARNING OBJECTIVES
1. Explain the uses and limitations of a statement of financial position.
2. Identify the major classifications of the statement of financial position.
3. Prepare a classified statement of financial position using the report and account formats.
4. Indicate the purpose of the statement of cash flows.
CHAPTER REVIEW
*Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.
1. Chapter 5 presents a detailed discussion of the concepts and techniques that underlie the
preparation and analysis of the statement of financial position. Along with the mechanics
of preparation, acceptable disclosure requirements are examined and illustrated. A brief
Statement of Financial Position
2. (L.O. 1) For many years financial statement users generally considered the income
statement to be superior to the statement of financial position as a basis for judging the
economic well-being of an enterprise. However, the statement of financial position can be a
3. Criticism of the statement of financial position has revolved around the limitations of the
4. The problem with fair value information concerns the reliability of such information. The
estimation process involved in developing fair value information causes a concern about
the objectivity of the resulting financial information. The use of estimates is extensive in
5. (L.O. 2) The major classifications used in the statement of financial position are assets,
liabilities, and equity. These items were defined in the discussion presented in Chapter 2.
To provide the financial statement reader with additional information, these major
classifications are divided into several subclassifications. Assets are further classified as
6. Items classified as long-term investments (or simply investments) in the assets section
of the statement of financial position normally are one of four types. These include:
7. Companies group investments in debt and equity securities into three separate portfolios
for valuation and reporting purposes.
a. Held-for-collection. Debt securities that a company manages to collect contractual
principal and interest payments. Individual securities are classified as non-current or
8. Property, plant and equipment are tangible properties of a durable nature that are used
9. Intangible assets lack physical substance and are not financial instruments; however,
their benefit lies in the rights they convey to the holder. Examples include patents,
copyrights, franchises, goodwill, trademarks, trade names, and customer lists.
10. Limited-life intangible assets (such as patents) are amortized over their useful lives.
11. Many companies include an “Other Assets” classification in the statement of financial
position after Intangible Assets. This section includes a wide variety of items that do not
12. Current assets are cash and other assets expected to be converted into cash, sold, or
consumed either in one year or in the operating cycle, whichever is longer. There are
some exceptions to a literal interpretation of the current asset definition. These exceptions
involve prepaid expenses, available-in-sale securities, and the subsequent years’
depreciation of fixed assets. These exceptions are recognized in the accounting process and
13. The Equity (also referred to as Shareholders’ Equity) section is difficult to prepare and
understand because of the complexity of capital share agreements, restrictions on equity
imposed by corporation law, liability agreements, and boards of directors. It consists of six
parts.
a. Share capital. The par or stated value of shares issued. It includes ordinary shares
and preference shares.
14. Non-current liabilities are obligations whose settlement date extends beyond the normal
operating cycle or one year, whichever is longer. Examples include bonds payable, notes
payable, lease obligations, and pension obligations. Generally, the disclosure require-
ments for long-term liabilities are quite substantial as a result of various covenants and
15. Current liabilities are the obligations that are reasonably expected to be settled either
through the use of current assets or the creation of other current liabilities. Items normally
16. Working capital is the excess of current assets over current liabilities. This concept,
sometimes referred to as net working capital, represents the net amount of a company’s
17. (L.O. 3) IFRS do not specify the order or format in which a company presents items in
the statement of financial position. The account format of a classified statement of
Statement of Cash Flows
18. (L.O. 4) The primary purpose of a statement of cash flows is to provide relevant
19. (L.O. 5) In accomplishing its purpose, the statement focuses attention on three different
activities related to cash flows.
a. Operating activities involve the cash effects of transactions that enter into determination
of net income.
The basic format of the statement of cash flows is shown below.
Statement of Cash Flows
Cash flows from operating activities .................. RXXX
20. The statement’s value is that it helps users evaluate liquidity, solvency, and financial
flexibility. Liquidity refers to the “nearness to cash” of assets and liabilities. Solvency is
21. (L.O. 6) The information to prepare the statement of cash flows comes from three sources:
(a) comparative statement of financial position, (b) the current income statement, and
(c) selected transaction data. Preparation of the statement of cash flows involves the
following steps.
a. Determine the cash provided by (or used in) operating activities.
22. (L.O. 7) Creditors look for answers to the following questions in the company’s cash flow
statement:
a. How successful is the company in generating net cash provided by operating activities?
23. The formula to calculate the current cash debt coverage ratio is:
24. The formula to calculate the cash debt coverage ratio is:
25. Free cash flow is the amount of discretionary cash flow a company has for purchasing
additional investments, retiring its debt, purchasing treasury stock, or simply adding to its
liquidity as follows:
Additional Information
26.(L.O. 8) Companies must provide comparative information in addition to the current year’s
financial statements, i.e., two complete sets of financial statements and related notes.
27. Generally the first note to the financial statements is a Summary of Significant Accounting
28. In addition, IFRS require many specific disclosures concerning such items as property,
plant, and equipment, receivables, inventories, employee benefits, and equity capital and
29. (L.O. 9) Effective communication of the information required to be disclosed in financial
statements is an important consideration. Accountants have developed certain methods
30. Other important issues related to the presentation of information in the financial
statements include offsetting, consistency, and fair presentation. Offsetting is not
*31. (L.O. 10) Appendix 5A Ratio Analysis—A Reference demonstrates various ratios used
to analyze financial performance and examine trends and relationships between financial
statement items.
LECTURE OUTLINE
It should be emphasized that this chapter is a review chapter and the intent is to provide
an overview for topics that will be dealt with in greater detail in later chapters.
As a review of Chapters 4 and 5, we recommend that you encourage students to examine
a set of actual financial statements and the accompanying notes. Appendix 5-B in the text
contains specimen financial statements for the Marks and Spencer Group.
The following lecture outline is appropriate for the chapter.
A. (L.O. 1) Usefulness of the Statement of Financial Position.
1. Provides information about entity’s assets, liabilities, and equity.
B. Limitations of the Balance Sheet.
1. Fair value is not reflected, since most assets and liabilities are reported at historical
cost.
2. Estimates and judgments must be utilized:
C. (L.O. 2) Classifications in the statement of financial position. Review definitions of the
elements on text page 2-13.
1. Assets.
D. Major Subclassifications in the statement of financial position: Non-current assets.
1. Long-term investments—management intent is to hold these investments for an
extended period of time.
a. Investments in securities: bonds, common stock, long-term notes.
e. Types of investment portfolios used for valuation and reporting purposes:
(1) Held-for-collection: debt securities that a company manages to collect
contractual principal and interest payments; classified as current or non-
2. Property, plant, and equipment—tangible long-lived assets such as land, buildings,
machinery, furniture, and “wasting resources” (timberland, minerals) used in operations.
a. Most assets in this category are either depreciable (e.g., buildings) or consumable
(e.g., minerals). Land is not depreciated. However, land improvements are
depreciated.
3. Intangible assets—resources that lack physical substance and are not financial
instruments but provide economic rights and advantages.
a. Examples include patents, franchises, copyrights, goodwill, trademarks, trade names,
and customer lists.
4. Other assets—a special classification for unusual items that cannot be included in one
of the other asset categories.
a. Examples include long-term prepaid expenses, non-current receivables, and prepaid
pension cost.
5. Current assets.
a. Resources which are expected to be turned into cash, sold, or consumed within a
b. Conceptual weaknesses in the classification of current assets:
(1) Prepaid expenses will neither be turned into cash nor used to pay a current
liability. Discuss the justification for including them in current assets.
(3) Prepaid expenses—expenses prepaid beyond the current operating cycle are
reported in the “other asset” section.
(4) Short-term investments—a company should report trading securities
(whether debt or equity) as current assets. Individual non-trading
(5) Cash—any cash restricted for purposes other than current obligations is
6. Equity—difficult to prepare and understand. Divided into six parts.
a. Share capital. The par or stated value of shares issued. It includes ordinary
shares and preference shares.
d. Accumulated other comprehensive income. Also referred to as reserves or
other reserves, includes such items as unrealized gains and losses on available-
7. Non-current liabilities.
a. Definition: Obligations that a company does not reasonably expect to liquidate
within the longer of one year or one normal operating cycle.
b. Three types:
(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
(e.g., service or product warranties).
8. Current liabilities.
a. Definition: Obligations that the company reasonably expects to settle within its
normal operating cycle or one year, whichever is longer.
b. Examples:
(1) Payables resulting from the acquisition of goods and services: accounts
payable, salaries and wages payable, income taxes payable.
d. Some liabilities that will be paid within a year are reported as long-term liabilities.
These include:
(1) short-term debt expected to be refinanced.
Working capital = Current assets minus current liabilities.
E. (L.O. 3) Statement of financial position format.
F. Statement of Cash Flows.
1. (L.O. 4) Purpose of the statement.
a. To provide information about the cash receipts and cash payments of an entity
2. The statement is useful because it provides answers to the following important
questions:
a. Where did cash come from?
3. (L.O. 5 and 6) Classification of cash flows.
a. Operating activities. The cash flows connected with the determination of net
income.
4. Significant noncash transactions.
b. Examples of transactions that must be disclosed:
5. Investing activities and financing activities.
Investing Activities Financing Activities
Sale of property, plant, and equipment Issuance of equity securities
Sale of investments in other entities Issuance of debt
6. Chapter 23 discusses preparation of the statement of cash flows in detail.
G. (L.O. 7) Usefulness of the statement of cash flows:
1. Information on the statement is used to evaluate financial liquidity and financial
flexibility.
2. Analysis of net cash provided by operating activities includes:
a. Current cash debt coverage: used to determine if a company can pay off its cur-
H. (L.O. 8) Notes to the financial statements.
1. Summary of Significant Accounting Policies
2. Disaggregated information about:
(a) Property, plant, and equipment, with related accumulated depreciation.
1. Parenthetical explanations (example: “net of tax” calculations in Chapter 4).
4. Other guidelines.
J. (L.O. 10) APPENDIX 5-A. Ratio Analysis.
1. Used to express the relationships between selected financial statement data.
2. Can be classified as:
a. Liquidity ratios: measure the short-run ability to pay maturing obligations.
