Chapter 5: Financial Position and Cash Flows

Question 1

Importance of the Statement of Financial Position

Answer 1

Statement of Financial Position (SFP) also known as the balance sheet under ASPE

SFP provides information:
- For evaluating the capital structure and
- For computing rates of return on invested assets

It is also useful for assessing a company’s:
- Liquidity (time until asset is realized or liability has to be paid)
- Solvency (ability to pay debts and related interest)
- Financial flexibility (ability to respond to unexpected needs and opportunities)

Question 2

Statement of Financial Position: Limitations

Answer 2

1. Many assets and liabilities are stated at historical cost
   - Information presented is reliable, however
   - Reporting at current fair value would result in more relevant information
2. Judgment and estimates are used in determining many of the items reported on the SFP
3. SFP does not report items that cannot be recorded objectively (e.g. internally generated goodwill)

Question 3

Statement of Financial Position: Classification

Answer 3

Similar items are classified (grouped together), with sub-totals

Considerations for reporting items separately:
1. Assets that differ in their type or expected function (e.g. inventory versus capital assets)
2. Liabilities with different implications for the entity’s financial flexibility (e.g. long term debt versus current debt)
3. Assets and liabilities with different general liquidity characteristics (e.g. cash versus receivables)
4. Assets, liabilities, and equities with characteristics that allow for easy measurement or valuation

Question 4

Current Assets

Answer 4

• Current assets are cash and other assets expected to be realized:
  - Within one year from the balance sheet date or
  - Within the normal operating cycle, whichever is longer
• Generally presented in order of liquidity (normally: cash, short-term investments, receivables, inventory, and prepaid expense)

Question 5

Current Assets – Cash

Answer 5

Includes cash and cash equivalents

Defined as:
- Cash, demand deposits, short-term liquid investments convertible to a known cash amount, and not subject to material value changes
- Any known restrictions to availability of cash must be disclosed

Question 6

Current Assets – Short-Term Investments

Answer 6

• Investments in debt and equity securities are presented separately from other assets
• Valued at cost/amortized cost or fair value

Question 7

Current Assets – Receivables

Answer 7

• Amounts should be reported separately based on the nature of their origin:
  1. Ordinary trade accounts
  2. Amounts owing by related parties
  3. Other (substantial) unusual items
• Separate disclosure required for:
  1. Amount and nature of nontrade receivables
  2. Receivables pledged as collateral
• Accounts receivable valued at net realizable value

Question 8

Current Assets – Inventories

Answer 8

Assets that are:
- Held for sale in the ordinary course of business
- In the process of production for such sale, or
- In the form of materials or supplies to be consumed in the production process or in the rendering of service

Valued at lower of cost and net realizable value
- Cost is determined by a cost formula (e.g. FIFO, weighted average, specific item) and must be disclosed

Manufacturing enterprise should disclose completion stage of inventories:
- Raw materials
- Work in progress
- Finished goods

Question 9

Current Assets – Prepaid Expenses

Answer 9

Defined as: expenditures already made for benefits to be received within one year or operating cycle (whichever is longer)

Current practice is to report some prepaid amounts as current assets even if the benefit extends beyond one year (or operating cycle)

Question 10

Non-current Investments

Answer 10

Non-current investments normally consist of one of the following:
- Debt securities
- Equity securities
- Sinking funds (a fund established by setting aside revenue over a period of time to fund a future capital expense, or repayment of a long-term debt.)
- Tangible assets held as investments

Investments are intended to be held for an extended period of time

Valuation options are:
- Fair value
- Amortized cost
- Equity Method

Question 11

Property, Plant, and Equipment

Answer 11

• Physical (tangible) assets used in on-going business operations of the business to generate income
• Generally reported at cost or amortized cost
• IFRS allows for valuation at fair value
• Most assets are depreciable, except for land
• Written down when impaired

Question 12

Intangible Assets

Answer 12

Intangible Assets are capital assets without physical substance, held to generate revenue

• Higher degree of uncertainty regarding future benefits
• Include (most common): Patents, copyrights, franchises, trademarks, and trade names
• Intangibles are grouped into two categories:
  - Those with finite life – amortized over useful life
  - Those with indefinite life – not amortized
  
  • Both are tested for impairment

Question 13

Goodwill

Answer 13

Goodwill may be acquired in a business combination
- Not amortized
- Tested for impairment

Question 14

Other Assets

Answer 14

• Assets in special funds
• Non-current receivables
• Deferred income tax assets
• Property held for sale
• Advances to subsidiaries

Question 15

Current Liabilities

Answer 15

Obligations due within one year (from the date of the SFP) or within the operating cycle, whichever is longer

Accounts payable normally listed first; however, current liabilities not reported in any specific order

Question 16

Working Capital

Answer 16

Working Capital = Current Assets - Current Liabilities

• A key indicator of the company’s short-term liquidity
• Not usually disclosed on the SFP
• Often calculated by bankers and other creditors

Question 17

Long-Term Liabilities

Answer 17

• Long-term obligations are those not expected to be paid within the normal operating cycle
• Three types:
  - Obligations arising from specific financing situations (e.g. bonds)
  - Obligations from ordinary operations of the business (e.g. pension obligations)
  - Obligations arising from ordinary business operations that are contingent on future events (e.g. product warranty)
• SFP presentation requires reporting the portion due within the next year as a current liability

Question 18

Shareholders’ Equity

Answer 18

• Capital Shares
• Contributed Surplus
• Retained Earnings (Deficit)
• Accumulated Other Comprehensive Income

Question 19

Shareholders’ Equity - Capital Shares

Answer 19

Exchange value of issued shares
Disclose authorized, issued, and outstanding amounts

Question 20

Shareholders’ Equity - Contributed Surplus

Answer 20

Term used whenever shares are sold at a price above their stated par value

Usually reported as one amount
Includes issued share premiums

Question 21

Shareholders’ Equity - Retained Earnings (Deficit)

Answer 21

The amount of undistributed accumulated earnings/losses
Presented as one item

Question 22

Shareholders’ Equity - Accumulated Other Comprehensive Income

Answer 22

Includes unrealized gains and losses on FV-OCI investments, certain types of donations, etc.

Question 23

SFP - Other Required Disclosures

Answer 23

1. Contingencies (ASPE) and provisions (IFRS)
   - Material events that have an uncertain outcome
   - Contingent gains not recognized under IFRS or ASPE; note disclosure
2. Accounting policies
   - Pprinciples and methods chosen
   - Use of estimates
3. Contractual situations
   - Contractual obligations (terms and conditions)
   - Commitments that require specific actions (e.g. maintain working capital at a certain level) if material
4. Subsequent events
   - Further evidence of conditions that existed
   - Conditions that occurred after the statement date
5. Additional detail

Question 24

Techniques of Disclosure

Answer 24

1. Parenthetical explanations (following the items in the SFP)—brings the information into the body of the statement
2. Notes (to the SFP)—reduces amount of detail on statements
3. Cross references, and contra and adjunct items (such as Accumulated Depreciation and Bond Premiums)
4. Supporting schedules to provide detail for single line items
5. Terminology

Question 25

Statement of Cash Flows

Answer 25

• To assess the firm’s ability to generate cash and cash equivalents and
• To allow comparison of the operating performance and cash flows of different entities

Statement of Cash Flows shows:
- Where the cash came from
- What the cash was used for
- The change in the cash balance

Question 26

Categories of cash activities

Answer 26

Operating Activities: Main revenue-producing activities
Investing Activities: Changes in long-term assets and investments
Financing Activities: Changes in equity and borrowings

Question 27

Statement of Cash Flows - Preparation Methods

Answer 27

Direct method: restates operations on a cash basis; includes specific cash inflows/outflows (e.g. cash received from customers, cash paid to suppliers and employees, interest paid/received, taxes paid, etc.)

Indirect method: reconciles accrual net income to cash-based net income (e.g. adds back non-cash charges deducted from net income, such as depreciation)

Only the operating activities section differs between the two methods

Question 28

Usefulness of the Statement of Cash Flows

Answer 28

Provides creditors with useful information:
- Company’s ability to generate net cash from operating activities
- Net cash flow trends or patterns from operating activities
- Major reasons for positive or negative net cash from operating activities
- Whether the cash flows are renewable or sustainable

Question 29

Financial Liquidity

Answer 29

Cash debt coverage ratio: indicates a company’s ability to repay its liabilities from net cash provided by operating activities without having to liquidate the assets it uses in its operations

Current cash debt coverage Ratio = Net cash provided by operating Activities ÷ Average current liabilities

Question 30

Financial Flexibility

Answer 30

Cash debt coverage ratio: indicates a company’s ability to repay its liabilities from net cash provided by operating activities without having to liquidate the assets it uses in its operations

Cash debt coverage Ratio = Net cash provided by Operating Activities ÷ Average Total Liabilities

Question 31

Perspectives

Answer 31

Cash Flow Patterns
- There may be useful patterns from operating, investing and financing activities
- Predictive value

Free Cash Flow
- Calculated as net cash from operations less capital expenditures and dividends
- Indicates discretionary cash flow (cash left to invest or expand) to make additional investments, to retire its debt, or to add to its liquidity
- Free cash flow analysis answers questions:
- Can the company pay dividends without external financing?
- If operations decline, will the company be able to maintain its required capital investment.