5.2 and 5.3: Usefulness and Limitations of the Statement of Financial Position Flashcards
What is the purpose of the Statement of Financial Position (SFP)?
The SFP, also called the balance sheet under ASPE, reports a business enterprise’s assets, liabilities, and shareholders’ equity at a specific date. It provides information on investments in resources, obligations to creditors, and owners’ equity, helping predict future cash flows.
How is the Statement of Financial Position (SFP) useful in evaluating a company?
The SFP helps analyze a company’s** liquidity, solvency, and financial flexibility.**
It also aids in assessing business risk and future cash flows, while providing a basis for calculating rates of return on invested assets and evaluating an enterprise’s capital structure.
What is liquidity and how is it measured?
Liquidity refers to the amount of time expected to pass until an asset is realized (converted into cash) or a liability is paid.
It is measured using ratios such as the current ratio, quick (acid-test) ratio, and current cash debt coverage ratio, which assess a company’s ability to cover short-term liabilities.
What are turnover ratios used for?
Turnover ratios, such as activity ratios, are used to assess how quickly a company’s receivables or inventories are collected or sold.
These ratios help creditors assess the company’s short-term liquidity and ability to meet current obligations.
What is solvency and why is it important?
Solvency reflects an enterprise’s ability to pay its debts and related interest.
Companies with higher debt levels compared to assets are at greater risk of insolvency, as more of their assets are required to meet fixed obligations like interest and principal payments.
Solvency is often measured using coverage ratios.
How does financial flexibility affect a company?
inancial flexibility measures a company’s ability to take effective actions to alter the amounts and timing of cash flows to respond to unexpected needs and opportunities.
A company with high financial flexibility can better survive bad times, recover from setbacks, and take advantage of profitable opportunities.
What is the purpose of classifying accounts in the Statement of Financial Position (SFP)?
Accounts are classified to group similar items together, enabling significant subtotals to be shown and revealing important relationships.
How can the classification in the SFP help financial statement users?
Classification helps users assess amounts, timing, and uncertainty of future cash flows, and evaluate liquidity, financial flexibility, profitability, and risk by grouping items with similar characteristics and separating items with different characteristics.
What are the key groupings in the Statement of Financial Position based on similar characteristics?
Different types or functions: Assets with different purposes (e.g., inventory vs. property, plant, and equipment) are reported separately.
Different implications for financial flexibility: Liabilities and equity items affecting financial flexibility are reported separately (e.g., long-term liabilities vs. current liabilities).
Different liquidity characteristics: Assets/liabilities with different liquidity characteristics are reported separately (e.g., property held for sale vs. property used by the company).
Ease of valuation: Certain assets/liabilities that are easier to measure (e.g., monetary vs. nonmonetary assets) are reported separately.
What is the difference between monetary and nonmonetary assets and liabilities?
Monetary assets: Claims to future cash flows that are fixed or determinable in amount and timing (e.g., cash, accounts receivable).
Nonmonetary assets: Assets whose value is not fixed in terms of a monetary unit (e.g., inventory, property, plant, and equipment).
Why is the historical cost often used for nonmonetary assets?
Nonmonetary assets are frequently recorded at their historical cost because their value in terms of a monetary unit is not fixed, leading to additional measurement uncertainty.
What are financial instruments?
Financial instruments are contracts between two or more parties that create a financial asset for one party and a financial liability or equity instrument for the other.
They are often marketable or tradable.
What are some examples of financial assets?
Cash
Contractual rights to receive cash or another financial instrument
Equity instruments of other companies
What is the ‘fair value option’ in accounting for financial instruments?
The fair value option allows entities to value financial instruments at fair value, reflecting an objective view of the instrument’s measurement, even recognizing gains/losses as booked through net income.
What are the general implications of grouping items in the SFP?
Grouping items provides insight into financial flexibility, liquidity, and risk, helping users understand the entity’s ability to meet its obligations and invest in opportunities.
