Applying the direct method and the indirect method of reporting cash flows c. Presenting the required information about noncash investing and financing activity and other events d. Classifying cash receipts and payments related to hedging activities.
Assess the reasons for differences between net income and associated cash receipts and payments d. That information not only complements information about the components of income, but also 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 and financial flexibility of the enterprise.
Solvency refers to the ability of an enterprise 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. Information on long-term obligations, such as long-term debt and notes payable, in comparison to total assets can be used to assess resources thatwill be needed to meet these fixed obligations suchas interest and principal payments.
Financial flexibility is the ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities.
An enterprise 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 the financial flexibility, the lower the risk of enterprise failure. Some situations in which estimates affect amounts reported in the balance sheet include: a allowance for doubtful accounts. When estimates are required, there is subjectivity in determining the amounts. Such subjectivity can impact the usefulness of the information by reducing the faithful representation of the measures, either because of bias or lack of verifiability.
An increase in inventories increases current assets, which is in the numerator of the current ratio. Therefore, inventory increases will increase the current ratio.
In general, an increase in the current ratio indicates a company has better liquidity, since there are more current assets relative to current liabilities. Note to instructors—When inventories increase faster than sales, this may not be a good signal about liquidity. That is, inventory can only be used to meet current obligations when it is sold and converted to cash.
That is why some analysts use a liquidity ratio—the acid-test ratio—that excludes inventories from current assets in the numerator. Liquidity describes the amount of time that is expected to elapse until an asset is converted into cash or until a liability has to be paid. The ranking of the assets given in order of liquidity is: 1 d Short-term investments.
The major limitations of the balance sheet are: a The values stated are generally historical and not at fair value. Being able to reliably measure the expected future benefits and to control the use of an item are essential elements of the definition of an asset, according to the Conceptual Framework. Classification in financial statements helps users by grouping items with similar characteristics and separating items with different characteristics. Current assets are expected to be converted to cash within one year or the operating cycle, whichever is longer—property, plant and equipment will provide cash inflows over a longer period of time.
Thus, separating long-term assets from current assets facilitates computation of useful ratios such as the current ratio. Separate amounts should be reported for accounts receivable and notes receivable. The amounts should be reported gross, and an amount for the allowance for doubtful accounts should be deducted. The amount and nature of any nontrade receivables, and any amounts designated or pledged as collateral, should be clearly identified.
Available-for-sale securities should be reported as a current asset only if management expects to convert them into cash as needed within one year or the operating cycle, whichever is longer. If available-for-sale securities are not held with this expectation, they should be reported as long-term investments.
The relationship between current assets and current liabilities is that current liabilities are those obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities. Working capital is the excess of total current assets over total current liabilities. This excess is sometimes called net working capital.
That is, it is the liquidity buffer available to meet the financial demands of the operating cycle. Assumes that the company still owns these assets.
The method most generally followed is to deduct from the total accounts receivable the amount of the allowance for doubtful accounts. Assets are defined as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.
If a building is leased under a capital lease, the future economic benefits of using the building are controlled by the lessee tenant as the result of a past event the signing of a lease agreement. Battle is incorrect. Retained earnings is a source of assets, but is not an asset itself. For example, even though the funds obtained from issuing a note payable are invested in the business, the note payable is not reported as an asset.
It is a source of assets, but it is reported as a liability because the company has an obligation to repay the note in the future. Similarly, even though the earnings are invested in the business, retained earnings is not reported as an asset. The notes should appear as long-term liabilities with full disclosure as to their terms. The purpose of a statement of cash flows is to provide relevant information about the cash receipts and cashpayments of an enterprise during a period.
It differs from the balance sheet and the income statement in that it reports the sources and uses of cash by operating, investing, and financing activity classifications. While the income statement and the balance sheet are accrual basis statements, the statement of cash flows is a cash basis statement—noncash items are omitted. The difference between these two amounts may be due to increases in current assets e.
Similarly a cash payment that results in a decrease in an existing current liability e. The difference between these two amounts could be due to noncash charges that appear in the income statement. Examples of noncash charges are depreciation, depletion, and amortization of intangibles. Expenses recorded but unpaid e. Operating activities involve the cash effects of transactions that enter into the determination of net income.
Investing activities include making and collecting loans and acquiring and disposing of debt and equity instruments; property, plant, and equipment and intangibles. The issuanceis reported as follows: Cash flows from financing activities Issuance of preferred stock The increase in Land is reported as follows: Cash flows from investing activities: Purchase Land The companyappears to have good liquidity and reasonable financial flexibility.
Its current cashdebt coverage is 1. In addition, its cash debt coverage is also good at 0. Free cash flow is net cash provided by operating activities less capital expenditures and dividends. The purpose of free cash flow analysis is to determine 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 and financial flexibility.
Some of the techniques of disclosure for the balance sheet are: a Parenthetical explanations. This note should be very useful from a comparative standpoint, since it should be easy to determine whether the company uses the same accounting policies as other companies in the same industry. General debt obligations, lease contracts, pension arrangements and stock option plans are four items for which disclosure is mandatory in the financial statements.
This term has a connotation outside accounting that is quite different from its meaning in the accounts or in the balance sheet. The use of the terms capital surplus, paid-in surplus, and earned surplus is confusing to the nonaccountant and leads to misinterpretation. If, on the other hand, the preferred stock is not a trading security, it should be classified as available-for-sale. Available-for-sale securitiesare classified as current or noncurrent depending upon the circumstances.
This account will be shown net of any billings on the contract. On the other hand, if the warehouse is being constructed for the use of this particular company, it should be classified as a separate item in the property, plant, and equipment section.
XXX Less: Allowance for doubtful accounts XXX Receivables—officers XXX Inventories Finished goods XXX Work in process XXX Raw materials XXX Land held for future plant site XXX Restricted cash plant expansion XXX Total long-term investments XXX Property,plant,and equipment Buildings XXX Less: Accum.
XXX Total assets XXX Unearned subscriptions revenue XXX Unearned rent revenue XXX Total current liabilities XXX Additional paid-in capital: Paid-in capitalin excessof par common stock XXX Total paid-in capital XXX Retained earnings XXX Totalpaid-in capitaland retained earnings XXX Less: Treasury stock, at cost Since these conditions are not met an accrual is not required.
The allowance for doubtful accounts is a valuation account contra asset and is deducted from accounts receivable on the balance sheet. Theliabilityis recorded on the date of declaration. Its financial flexibility is good. It might be noted that it substantially reducedits long-term debtin which will help its financial flexibility.
Information is available to compute all the asset amounts except current assets and therefore current assets can be determined by deducting the total of all the other asset balances from the total asset balance i. It appears the company has good liquidity and financial flexibility. No monetary amounts are to be reported.
Problem Time 35—40 minutes Purpose—to provide the student with the opportunity to prepare a complete balance sheet, involving dollar amounts. A unique feature of this problem is that the student must solve for the retained earnings balance. Problem Time 40—45 minutes Purpose—to provide an opportunity for the student to prepare a balance sheet in good form. Emphasis is given in this problem to additional important information that should be disclosed.
For example, an inventory valuation method, bank loans secured by long-term investments, and information related to the capital stock accounts must be disclosed. Problem Time 40—45 minutes Purpose—to provide the student with the opportunity to analyze a balance sheet and correct it where appropriate. The balance sheet as reported is incomplete, uses poor terminology, and is in error.
A challenging problem. Problem Time 40—45 minutes Purpose—to provide the student with the opportunity to prepare a balance sheet in good form. Additional information is provided on each asset and liability category for purposes of preparing the balance sheet. Problem Time 35—45 minutes Purpose—to provide the student with an opportunity to prepare a complete statement of cash flows.
A condensed balance sheet is also required. The student is also required to explain the usefulness of the statement of cash flows. Because the textbook does not explain in Chapter 5 all of the steps involved in preparing the statement of cash flows, assignment of this problem is dependent upon additional instruction by the instructor or knowledge gained in elementary financial accounting.
Problem Time 40—50 minutes Purpose—to provide the student with an opportunity to prepare a balance sheet in good form and a more complex cash flow statement. XXX Accounts receivable XXX Advances to employees XXX Inventory ending XXX Prepaid rent XXX Total current assets XXX Cash surrender value of life insurance XXX Land for future plant site XXX Property,plant,and equipment Land XXX Buildings XXX Intangible assets Copyrights XXX Patents XXX Total intangible assets XXX Salaries and wages payable XXX Dividends payable XXX Total long-term liabilities XXX Total liabilities XXX Common stock description XXX Totalpaid-in capital and retained earnings XXX Accumulated othercomprehensive income XXX Less: Treasury stock XXX Equity attributable to Noncontrolling interest Note that the appreciation capital account is also deleted.
Note 2 indicates that retained earnings was credited. Note that the goodwill account is also deleted. Note: As an alternate presentation, the cash restricted for plant expansion would be added to the general cash account and then subtracted.
The amount reported in the investments section would not change. For example,by showingthe specific inflows and outflows from operating activities,investingactivities,and financing activities,the user has a better understanding ofthe liquidity and financial flexibility of the enterprise. Similarly, these reports are usefulin providingfeedbackaboutthe flow ofenterprise resources.
This information should help users make more accurate predictions of future cash flow. In addition,someindividuals have expressed concern about the quality of the earnings because the measurement of the income dependson a numberof accruals and estimateswhich may be somewhatsubjective.
As a result,the higher the ratio of cash provided by operating activities to net income, the more comfort some users have in the reliability of the earnings. Overall, it appears that its liquidity position is average and overall financial flexibility and solvency should be improved. For example,by showingthe specific inflows and outflows from operating activities,investing activities,and financing activities, the user has a better understanding of the liquidity and financial flexibility of the enterprise.
Similarly, these reports are useful in providing feedback about the flow of enterprise resources. This informationshouldhelp users makemore accurate predictions of future cash flow. Accounting changes, additional assessments of income taxes, prior period adjustments, and changes in estimates are some of the financial transactions presented. CA Time 30—35 minutes Purpose—to present the asset section of a partial balance sheet that must be analyzed to assess its deficiencies.
Items such as improper classifications, terminology, and disclosure must be considered. CA Time 20—25 minutes Purpose—to present a balance sheet that must be analyzed to assess its deficiencies.
Items such as improper classification, terminology, and disclosure must be considered. CA Time 20—25 minutes Purpose—to present the student an ethical issue related to the presentation of balance sheet information. CA Time 40—50 minutes Purpose—to present a cash flow statement that must be analyzed to explain differences in cash flow and net income, and sources and uses of cash flow and ways to improve cash flow.
The new estimate would be used in computing depreciation expense for No adjustment of the balance in accumulated depreciation at the beginning of the year would be made. Instead, the remaining depreciable cost would be divided by the estimated remaining life. This is a change in an estimate and is accounted for prospectively in the current and future years. Disclosure in the notes to the financial statements is appropriate, if material. This transaction does not represent a prior period adjustment.
The effect of the error at December 31, , should be shown as an adjustment of the beginning balance of retained earnings on the retained earnings statement. Generally, an entry is made for a cash dividend on the date of declaration. The appropriate entry would be a debit to Retained Earnings or Dividends for the amount to be paid, with a corresponding credit to Dividends Payable.
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