CHAPTER THREE

STATEMENT OF FINANCIAL POSITION AND STATEMENT OF CASH FLOWS

The statement of financial position sometimes referred to as the balance sheet, reports the
assets, liabilities, and stockholders’ equity of a business enterprise at a specific date. This
financial statement provides information about the nature and amounts of investments in
enterprise resources, obligations to creditors, and the owners’ equity in net resources. It therefore
helps in predicting the amounts, timing, and uncertainty of future cash flows.

Usefulness of the SOFP

By providing information on assets, liabilities, and stockholders’ equity, the SOFP provides a
basis for computing rates of return and evaluating the capital structure of the enterprise. Analysts
also use information in the SOFP to assess a company’s risk and future cash flows. In this
regard, analysts use the SOF to assess a company’s liquidity, solvency, and financial flexibility.
Liquidity describes “the amount of time that is expected to elapse until an asset is realized or
otherwise converted into cash or until a liability has to be paid.” Creditors are interested in short-
term liquidity ratios, such as the ratio of cash (or near cash) to short-term liabilities. Stockholders
assess liquidity to evaluate the possibility of future cash dividends or the buyback of shares. In
general, the greater Co.’s liquidity, the lower its risk of failure.
Solvency refers to the ability of a company 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 than a
similar company with a low level of long-term debt. Companies with higher debt are relatively
more risky because they will need more of their assets to meet their fixed obligations (interest
and principal payments).
Liquidity and solvency affect a company’s financial flexibility, which measures 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.” For example, a company may become so loaded
with debt—so financially inflexible—that it has little or no sources of cash to finance expansion
or to pay off maturing debt. A company 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 an enterprise’s financial
flexibility, the lower its risk of failure.

Limitations of the SOFP

Some of the major limitations of the SOFP are:
1. Most assets and liabilities are reported at historical cost. As a result, the information
provided in the SOFP is often criticized for not reporting a more relevant fair value. For
example, some assets that may appreciate in value after purchase. Yet, the company
reports any increase only if and when it sells the assets.
2. Companies use judgments and estimates to determine many of the items reported in the
balance sheet. For example, in its balance sheet, company’s estimates the amount of
receivables that it will collect, the useful life of its warehouses, and the number of
computers that will be returned under warranty.
3. The SOFP necessarily omits many items that are of financial value but that a company
cannot record objectively. For example, the knowledge and skill of company’s
employees in developing new computer chips are arguably the company’s most
significant assets. However, because company’s cannot reliably measure the value of its

1|P ag e
 employees and other intangible assets (such as customer base, research superiority, and
reputation), it does not recognize these items in the balance sheet. Similarly, many
liabilities are reported in an “off-balance-sheet” manner, if at all.

Element of the SOFP

1. ASSETS. Probable future economic benefits obtained or controlled by a particular entity

as a result of past transactions or events.
2. LIABILITIES. Probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to other entities in
the future as a result of past transactions or events.
3. EQUITY. Residual interest in the assets of an entity that remains after deducting its
liabilities. In a business enterprise, the equity is the ownership interest

Assets Liabilities and Owners’ Equity

Current assets Current liabilities
Long-term investments Long-term debt
Property, plant, and equipment Owners’ equity
Intangible assets Capital stock
Investment property Additional paid-in capital
Biological asset Retained earnings
Other assets
A company may classify the SOFP in some other manner, but in practice you usually see little
departure from these major subdivisions.
Current Assets
Current assets are cash and other assets a company expects to convert into cash, sell, or
consume either in one year or in the operating cycle, whichever is longer. If the operating
cycle is more than one year, a company uses the longer period. Current assets are presented in
the SOFP in order of liquidity. The five major items found in the current assets section, and
their bases of valuation, are shown below:
Item Basis of Valuation
Cash and cash equivalents Fair value
Short-term investments Generally, fair value
Receivables Estimated amount collectible
Inventories Lower-of-cost-or-market
Prepaid expenses Cost

A company does not report these five items as current assets if it does not expect to realize them
in one year or in the operating cycle, whichever is longer. For example, a company excludes
from the current assets section cash restricted for purposes other than payment of current
obligations or for use in current operations. Generally, if a company expects to convert an
asset into cash or to use it to pay a current liability within a year or the operating cycle,
whichever is longer, it classifies the asset as current.

2|P ag e
Cash
Cash is generally considered to consist of currency and demand deposits (monies available on
demand at a financial institution). Cash equivalents are short-term highly liquid investments
that will mature within three months or less. Most companies use the caption “Cash and cash
equivalents,” and they indicate that this amount approximates fair value. A company must
disclose any restrictions or commitments related to the availability of cash.

Short-Term Investments
Companies group investments in debt and equity securities into three separate portfolios for
valuation and reporting purposes:
a. Held-to-maturity: Debt securities that a company has the positive intent and ability to
hold to maturity.
b. Trading: Debt and equity securities bought and held primarily for sale in the near term to
generate income on short-term price differences.
c. Available-for-sale: Debt and equity securities not classified as held-to-maturity or
trading securities.
A company should report trading securities (whether debt or equity) as current assets. It
classifies individual held-to-maturity and available-for-sale securities as current or noncurrent
depending on the circumstances. It should report held-to-maturity securities at amortized cost.
All trading and available-for-sale securities are reported at fair value.

Receivables
A company should clearly identify any anticipated loss due to uncollectable, the amount and
nature of any nontrade receivables, and any receivables used as collateral. Major categories of
receivables should be shown in the SOFP or the related notes. For receivables arising from
unusual transactions (such as sale of property, or a loan to affiliates or employees), companies
should separately classify these as long-term, unless collection is expected within one year.

Inventories
To present inventories properly, a company discloses the basis of valuation (e.g., lower of- cost-
or-market) and the cost flow assumption used (e.g., FIFO or WA).

Prepaid Expenses
A company includes prepaid expenses in current assets if it will receive benefits (usually
services) within one year or the operating cycle, whichever is longer. A company reports prepaid
expenses at the amount of the unexpired or unconsumed cost. A common example is the
prepayment for an insurance policy. A company classifies it as a prepaid expense because the
payment precedes the receipt of the benefit of coverage. Other common prepaid expenses include
prepaid rent, advertising, and office or operating supplies.

Noncurrent Assets
Noncurrent assets are those not meeting the definition of current assets. They include a variety of
items, as shown below:

3|P ag e
Long-Term Investments
Long-term investments: often referred to simply as investments, normally consist of one of four
types:
1. Investments in securities, such as bonds, common stock, or long-term notes.
2. Investments in tangible fixed assets not currently used in operations, such as land held for
speculation.
3. Investments set aside in special funds such as a sinking fund, pension fund, or plant
expansion fund. This includes the cash surrender value of life insurance.
4. Investments in nonconsolidated subsidiaries or affiliated companies.
Companies expect to hold long-term investments for many years. They usually present them on
the SOFP just below “Current assets,” in a separate section called “Investments.” Realize that
many securities classified as long-term investments are, in fact, readily marketable. But a
company does not include them as current assets unless it intends to convert them to cash in
the short-term—that is, within a year or in the operating cycle, whichever is longer.

Property, Plant, and Equipment

Property, plant, and equipment are tangible long-lived assets used in the regular operations of
the business. These assets consist of physical property such as land, buildings, machinery,
furniture, tools, and wasting resources (timberland, minerals). With the exception of land, a
company either depreciates (e.g., buildings) or depletes (e.g., timberlands or oil reserves) these
assets.
Investment property
Investment property is property (land or a building – or part of a building – or both) held (by
the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or
both.
Intangible Assets
Intangible assets lack physical substance and are not financial instruments. They include
patents, copyrights, franchises, goodwill, trademarks, trade names, and customer lists. A
company writes off (amortizes) limited-life intangible assets over their useful lives. It
periodically assesses indefinite-life intangibles (such as goodwill) for impairment.
Biological asset
• Biological asset (classified as a non-current asset) is a living animal or plant, such as
sheep, cows, fruit trees, or cotton plants.
• Agricultural produce is the harvested product of a biological asset, such as wool from a
sheep, milk from a dairy cow, picked fruit from a fruit tree, or cotton from a cotton plant.
• Harvest – is detachment of produce from a Biological asset or the cessation of biological
asset’s life.
NCA held for sales
Classification:
 Classify as held for sale if carrying amount will be recovered principally through a sale
transaction rather than through continuing use
 Asset or disposal group must be available for immediate sale in its present condition and
the sale must be highly probable (i.e. management must be committed to the disposal)
 Period to complete sale may extend beyond 1 year due to circumstances outside the
entity’s control

4|P ag e
Other Assets
The items included in the section “Other assets” vary widely in practice. Some include items
such as long-term prepaid expenses, prepaid pension cost, and noncurrent receivables. Other
items that might be included are assets in special funds, deferred income taxes, property held for
sale, and restricted cash or securities.

Liabilities
Similar to assets, companies classify liabilities as current or long-term.
Current Liabilities
Current liabilities are the obligations that a company reasonably expects to liquidate either
through the use of current assets or the creation of other current liabilities. This concept includes:
1. Payables resulting from the acquisition of goods and services: accounts payable, wages
payable, taxes payable, and so on.
2. Collections received in advance for the delivery of goods or performance of services,
such as unearned rent revenue or unearned subscriptions revenue.
3. Other liabilities whose liquidation will take place within the operating cycle, such as the
portion of long-term bonds to be paid in the current period or short-term obligations
arising from the purchase of equipment.
Companies do not report current liabilities in any consistent order. In general, though, companies
most commonly list notes payable, accounts payable, or short-term debt as the first item. Income
taxes payable, current maturities of long-term debt, or other current liabilities are commonly
listed last.

Current liabilities include such items as trade and nontrade notes and accounts payable, advances
received from customers, and current maturities of long-term debt. If the amounts are material,
companies classify income taxes and other accrued items separately. The excess of total current
assets over total current liabilities is referred to as working capital (or sometimes net working
capital). Working capital represents the net amount of a company’s relatively liquid resources.

Long-Term Liabilities
Long-term liabilities are obligations that a company does not reasonably expect to liquidate
within the normal operating cycle. Instead, it expects to pay them at some date beyond that time.
The most common examples are bonds payable, notes payable, some deferred income tax
amounts, lease obligations, and pension obligations.
Generally, long-term liabilities are of three types:
1. Obligations arising from specific financing situations, such as the issuance of bonds,
long-term lease obligations, and long-term notes payable.
2. Obligations arising from the ordinary operations of the company, such as pension
obligations and deferred income tax liabilities.
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, such as service
or product warranties and other contingencies.
Companies generally provide a great deal of supplementary disclosure for long term liabilities,
because most long-term debt is subject to various covenants and restrictions for the protection of
lenders.

5|P ag e
Owners’ Equity
The owners’ equity (stockholders’ equity) section is one of the most difficult sections to
prepare and understand. This is due to the complexity of capital stock agreements and the various
restrictions on stockholders’ equity imposed by state corporation laws, liability agreements, and
boards of directors. Companies usually divide the section into four parts:

Stockholder’s equity section:

1. Capital stock (share capital): The par or stated value of the shares issued.
2. Additional paid-in capital (share premium): The excess of amounts paid in over the
par or stated value.
3. Retained earnings: the Corporation’s undistributed earnings.
4. Accumulated other comprehensive income (accumulated OCI)

For capital stock, companies must disclose the par value and the authorized, issued, and
outstanding share amounts. A company usually presents the additional paid-in capital in one
amount, although subtotals are informative if the sources of additional capital are varied and
material.
The ownership or stockholders’ equity accounts in a corporation differ considerably from those
in a partnership or proprietorship. Partners show separately their permanent capital accounts and
the balance in their temporary accounts (drawing accounts). Proprietorships ordinarily use a
single capital account that handles all of the owner’s equity transactions.

SOFP Format
One common arrangement that companies use in presenting a classified SOFP is the account
form. It lists assets, by sections, on the left side, and liabilities and stockholders’ equity, by
sections, on the right side. The main disadvantage is the need for a sufficiently wide space in
which to present the items side by side. Often, the account form requires two facing pages. To
avoid this disadvantage, the report form lists the sections one above the other, on the same
page.

STATEMENT OF CASH FLOWS

One of the basic objectives of financial reporting is “assessing the amounts, timing, and
uncertainty of cash flows.” The three financial statements we have looked at so far: the income
statement, the statement of stockholders’ equity, and the balance sheet; each present some
information about the cash flows of an enterprise during a period. But they do so to a limited
extent. For instance, the income statement provides information about resources provided by
operations, but not exactly cash. The statement of stockholders’ equity shows the amount of cash
used to pay dividends or purchase treasury stock. Comparative balance sheets might show what
assets the company has acquired or disposed of and what liabilities it has incurred or liquidated.
Useful as they are, none of these statements presents a detailed summary of all the cash inflows
and outflows, or the sources and uses of cash during the period. To fill this need, the FASB
requires the statement of cash flows (also called the cash flow statement).

Purpose of the statement of cash flows

6|P ag e
The primary purpose of a statement of cash flows is to provide relevant information about the
cash receipts and cash payments of an enterprise during a period. To achieve this purpose, the
statement of cash flows reports the following: (1) the cash effects of operations during a period,
(2) investing transactions, (3) financing transactions, and (4) the 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 a company’s most liquid resource. The statement of cash flows
provides answers to the following simple but important questions:
1. Where did the cash come from during the period?
2. What was the cash used for during the period?
3. What was the change in the cash balance during the period?

Content and format of the statement of cash flows

Companies classify cash receipts and cash payments during a period into three different activities
in the statement of cash flows—operating, investing, and financing activities, defined as follows.
1. Operating activities involve the cash effects of transactions that enter into the
determination of net income.
2. Investing activities include making and collecting loans and acquiring and disposing of
investments (both debt and equity) and property, plant, and equipment.
3. Financing activities involve liability and owners’ equity items. They include (a)
obtaining resources from owners and providing them with a return on their investment,
and (b) borrowing money from creditors and repaying the amounts borrowed.
Illustration below shows the basic format of the statement of cash flows.

Statement of Cash Flows

Cash flows from operating activities $XXX
Cash flows from investing activities XXX
Cash flows from financing activities XXX
Net increase (decrease) in cash XXX
Cash at beginning of year XXX
Cash at end of year $XXX

The statement’s value is that it helps users evaluate liquidity, solvency, and financial
flexibility. As stated earlier, liquidity refers to the “nearness to cash” of assets and liabilities.
Solvency is the firm’s ability to pay its debts as they mature. Financial flexibility is a
company’s ability to respond and adapt to financial adversity and unexpected needs and
opportunities.

OVERVIEW OF THE PREPARATION OF THE STATEMENT OF CASH FLOWS

Sources of Information
Companies obtain the information to prepare the statement of cash flows from several sources:
(1) comparative balance sheets, (2) the current income statement, and (3) selected transaction
data.
The following simple example demonstrates how companies use these sources in preparing a
statement of cash flows.
On January 1, 2012, in its first year of operations, Telemarketing Inc. issued 50,000 shares of $1
par value common stock for $50,000 cash. The company rented its office space, furniture, and

7|P ag e
telecommunications equipment and performed marketing services throughout the first year. In
June 2012, the company purchased land for $15,000.
Illustration below shows the company’s comparative balance sheets at the beginning and end of
2012.
TELEMARKETING INC.
SOFP
Assets Dec. 31, 2012 Jan. 1, 2012 Increase/Decrease
Cash $31,000 $–0– $31,000 Increase
Accounts receivable 41,000 –0– 41,000 Increase
Land 15,000 –0– 15,000 Increase
Total $87,000 $–0–
Liabilities and Stockholders’ Equity
Accounts payable $12,000 $–0– 12,000 Increase
Common stock 50,000 –0– 50,000 Increase
Retained earnings 25,000 –0– 25,000 Increase
Total $87,000 $–0–

Illustration below presents the income statement and additional information.

TELEMARKETING INC.
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2012
Revenues $172,000
Operating expenses 120,000
Income before income tax 52,000
Income tax 13,000
Net income $ 39,000
Additional information: Dividends of $14,000 were paid during the year.
Preparing the Statement of Cash Flows
Preparing the statement of cash flows from these sources involves four steps:
1. Determine the cash provided by (or used in) operating activities.
2. Determine the cash provided by or used in investing and financing activities.
3. Determine the change (increase or decrease) in cash during the period.
4. Reconcile the change in cash with the beginning and the ending cash balances.

Cash provided by operating activities is the excess of cash receipts over cash payments from
operating activities. Companies determine this amount by converting net income on an accrual
basis to a cash basis. To do so, they add to or deduct from net income those items in the income
statement that do not affect cash. This procedure requires that a company analyze not only the
current year’s income statement but also the comparative balance sheets and selected transaction
data.
Analysis of Telemarketing’s comparative balance sheets reveals two items that will affect the
computation of net cash provided by operating activities:
1. The increase in accounts receivable reflects a noncash increase of $41,000 in revenues.
2. The increase in accounts payable reflects a noncash increase of $12,000 in expenses.

8|P ag e
Therefore, to arrive at cash provided by operations, Telemarketing Inc. deducts from net income
the increase in accounts receivable ($41,000), and it adds back to net income the increase in
accounts payable ($12,000). As a result of these adjustments, the company determines cash
provided by operations to be $10,000, computed as shown in Illustration below.
Net income $39,000
Adjustments to reconcile net income
to net cash provided by operating activities:
Increase in accounts receivable $(41,000)
Increase in accounts payable 12,000 (29,000)
Net cash provided by operating activities $10,000

Next, the company determines its investing and financing activities. Telemarketing Inc.’s only
investing activity was the land purchase. It had two financing activities:
1. Common stock increased $50,000 from the issuance of 50,000 shares for cash.
2. The company paid $14,000 cash in dividends. Knowing the amounts provided/ used by
operating, investing, and financing activities, the company determines the net increase in
cash.

Illustration below presents Telemarketing Inc.’s statement of cash flows for 2012.

TELEMARKETING INC.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2012
Cash flows from operating activities
Net income $39,000
Adjustments to reconcile net income to
net cash provided by operating activities:
Increase in accounts receivable $(41,000)
Increase in accounts payable 12,000 (29,000)
Net cash provided by operating activities 10,000
Cash flows from investing activities
Purchase of land (15,000)
Net cash used by investing activities (15,000)
Cash flows from financing activities
Issuance of common stock 50,000
Payment of cash dividends (14,000)
Net cash provided by financing activities 36,000
Net increase in cash 31,000

Cash at beginning of year –0–

Cash at end of year $31,000

The increase in cash of $31,000 reported in the statement of cash flows agrees with the increase
of $31,000 in cash calculated from the comparative balance sheets.

9|P ag e
Significant Noncash Activities
Not all of a company’s significant activities involve cash. Examples of significant noncash
activities are:
1. Issuance of common stock to purchase assets.
2. Conversion of bonds into common stock.
3. Issuance of debt to purchase assets.
4. Exchanges of long-lived assets
Significant financing and investing activities that do not affect cash are not reported in the body
of the statement of cash flows. Rather, these activities are reported in either a separate schedule
at the bottom of the statement of cash flows or in separate notes to the financial statements. Such
reporting of these noncash activities satisfies the full disclosure principle.

USEFULNESS OF THE STATEMENT OF CASH FLOWS

“Happiness is a positive cash flow” is certainly true. Although net income provides a long-term
measure of a company’s success or failure, cash is its lifeblood. Without cash, a company will
not survive. For small and newly developing companies, cash flow is the single most important
element for survival. Even medium and large companies must control cash flow.

Creditors examine the cash flow statement carefully because they are concerned about being
paid. They begin their examination by finding net cash provided by operating activities. A high
amount indicates that a company is able to generate sufficient cash from operations to pay its
bills without further borrowing. Conversely, a low or negative amount of net cash provided by
operating activities indicates that a company may have to borrow or issue equity securities to
acquire sufficient cash to pay its bills. Consequently, creditors look for answers to the following
questions in the company’s cash flow statements.
1. How successful is the company in generating net cash provided by operating activities?
2. What are the trends in net cash flow provided by operating activities over time?
3. What are the major reasons for the positive or negative net cash provided by operating
activities?
You should recognize that companies can fail even though they report net income. The
difference between net income and net cash provided by operating activities can be substantial.

ADDITIONAL INFORMATION
In previous chapter, we have discussed the primary financial statements that all companies
prepare in accordance with GAAP. However, the primary financial statements cannot provide the
complete picture related to the financial position and financial performance of the company.
Additional descriptive information in supplemental disclosures and certain techniques of
disclosure expand on and amplify the items presented in the main body of the statements.

The SOFPis not complete if a company simply lists the assets, liabilities, and owners’ equity
accounts. It still needs to provide important supplemental information. This may be information
not presented elsewhere in the statement, or it may elaborate on items in the balance sheet. There
are normally four types of information that are supplemental to account titles and amounts
presented in the balance sheet. They are listed below.

1. Contingencies: Material events that have an uncertain outcome.

10 | P a g e
 2. Accounting policies: Explanations of the valuation methods used or the basic
assumptions made concerning inventory valuations, depreciation methods, investments in
subsidiaries, etc.
3. Contractual situations: Explanations of certain restrictions or covenants attached to
specific assets or, more likely, to liabilities.
4. Fair values: Disclosures of fair values, particularly for financial instruments.

Contingencies
A contingency is an existing situation involving uncertainty as to possible gain (gain
contingency) or loss (loss contingency) that will ultimately be resolved when one or more future
events occur or fail to occur. In short, contingencies are material events with an uncertain future.
Examples of gain contingencies are tax operating loss carry forwards or company litigation
against another party. Typical loss contingencies relate to litigation, environmental issues,
possible tax assessments, or government investigations.
Accounting Policies
GAAP recommends disclosure for all significant accounting principles and methods that involve
selection from among alternatives or those that are peculiar to a given industry. For instance,
companies can compute inventories under several cost flow assumptions (e.g., LIFO and FIFO),
depreciate plant and equipment under several accepted methods (e.g., double-declining balance
and straight-line), and carry investments at different valuations (e.g., cost, equity, and fair value).
Contractual Situations
Companies should disclose contractual situations, if significant, in the notes to the financial
statements. For example, they must clearly state the essential provisions of lease contracts,
pension obligations, and stock option plans in the notes. Analysts want to know not only the
amount of the liabilities, but also how the different contractual provisions affect the company at
present and in the future.
Companies must disclose the following commitments if the amounts are material: commitments
related to obligations to maintain working capital, to limit the payment of dividends, to restrict
the use of assets, and to require the maintenance of certain financial ratios. Management must
exercise considerable judgment to determine whether omission of such information is
misleading.
Fair Values
As we have discussed, fair value information may be more useful than historical cost for certain
types of assets and liabilities. This is particularly so in the case of financial instruments.
Financial instruments are defined as cash, an ownership interest, or a contractual right to
receive or obligation to deliver cash or another financial instrument. Such contractual rights to
receive cash or other financial instruments are assets. Contractual obligations to pay are
liabilities. Cash, investments, accounts receivable, and payables are examples of financial
instruments.

11 | P a g e