CHAPTER 7

FINANCIAL STATEMENTS II:

 Introduction
Financial reports can be divided into two
categories
1. Results of the flows of resources over time (flows)
2. The status of resources at a point in time (stocks)

Statement
of
Retained
Earnings Balance
Sheet
Past Emphasis
Income statement
Based on the assumption that flows
were more important than stocks
Frequently resulted in the
measurement of stocks at
residual values
 FASB
Asset - Liability approach
Changes in balance sheet amounts becoming
more important in income determination
 In this chapter

Balance sheet and the associated measurement

techniques for its elements
Statement of cash flows and its evolution over time
 The Balance Sheet
Should disclose wealth of a company at a point in
time
Wealth is present value of all
Resources
Obligations
 The Balance Sheet
This measurement technique is limited
Consequently, a variety of measurement techniques are
used to measure the elements of the balance sheet
Historical (Historical cost)
Current oriented (Current value)
Future oriented (Expected realizable value)
 Balance Sheet Elements
The elements of the balance sheet were defined in SFAC No. 6 as:

Assets

Liabilities

Equity

Definitions arise from the FASBs asset - liability approach to

income determination
Departure from previous definitions that resulted in valuations
arrived at via the residual effect of income determination
 Components of the Balance Sheet

Assets Liabilities
Current assets Current liabilities
Investments Long-term debt
Property, plant, and equipment Other liabilities
Intangible assets
Other assets Stockholders Equity
Capital stock
Additional paid-in capital
Retained earnings
 Asset Valuation

Asset Measurement basis

Cash Current value

Accounts receivable Expected future value

Marketable securities Fair value

Inventory Current or past value

Investments Fair value, amortized cost, or

equity method

Prepaid items Historical cost

Property, plant and equipment Depreciated past value
 Liabilities and Their Associated
Measurement Techniques

Liability Measurement
Current Liabilities Liquidation Value
Long-term & Liquidation Value
Other Liabilities or Present Value

Do measurement techniques
bias statements in favor of
current investors?
 Stockholders Equity Accounts and Their
Associated Measurement Techniques

Account Measurement basis

Common Stock Historical Cost

(Par Value vs Selling Price)

Preferred Stock Historical Cost

Retained Earnings Dependent upon income

& Other Recognition
Comprehensive
Income
Fair Value Measurements under SFAS No. 157
(Now FASB ASC 820)
New definition for fair value
Fair value Hierarchy for sources of
information
New disclosures of assets and liabilities
Modification of presumption of transaction
price
 Illustration of Tabular Disclosures for Assets
Remeasured on a Nonrecurring Basis
($ in millions) Fair Value Measurements Using

Description Year Ended Quoted Prices

12/31/XX in Active
Markets for
Inputs Significant Significant
Identical 1 Other Unobservable
Assets Observable Inputs Total Gains
(Level 1) (Level 2) (Level 3) (Losses)
Long-lived
assets held
and used $75 $75 $(25)

Goodwill 30 $30 (35)

Long-lived
assets held for
sale 26 26 (15)

$(75)
Modification of Transaction Price Presumption

SFAS No 157 did away with presumption

Entities should consider whether certain
factors might indicate that transaction price
does not represent fair value
FASB Staff Position FAS No. 157-4
Some critics of SFAS No.157 maintained that it
caused or exacerbated the 20072008 market
crises by forcing a downward spiral of valuations
based on distressed institutions.
They also raised concerns that as a result of
SFAS No. 157 and SFAS No. 115 financial
institutions were forced to book losses on
securities that may have value after the credit
market crisis has passed.
However, proponents of the standard
maintained that suspending or revising SFAS
No. 157 would be a disservice
FASB Staff Position FAS No. 157-4

As a result of these differing viewpoints, financial institutions,

accounting groups, and others requested guidance from the SEC
and the FASB on how to determine fair value measurements in the
then-current economic climate.
On December 30, 2008, the SEC issued a study on fair value
accounting.
This study recommended that existing fair value accounting and
mark-to-market standards, including SFAS No. 157, should not be
suspended.
Later, after some contentious hearings in Congress, where the
FASBs standard-setting authority was threatened by some of its
members, the FASB amended SFAS No. 157 by issuing FASB Staff
Position (FSP). FAS 157-4 (see FASB ASC 820-10-65).
FASB Staff Position FAS No. 157-4

FSP FAS 157-4 provided guidance on how to

determine when the volume and level of activity
for an asset or liability has significantly
decreased and identified the circumstances in
which a transaction is not orderly.
Subsequently, after considering the significance
and relevance of each of the factors, judgment
should be used to determine whether the market
is active and if a significant adjustment to the
transactions or quoted prices may be necessary
to estimate fair value.
FASB Staff Position FAS No. 157-4
Although proponents and opponents of the amendment
differed on the economic consequences of its adoption,
both expected it to have a major impact.
The expectation was that it would result in the
revaluation upward of troubled assets, especially
mortgage-based securities, by lowering their fair value
hierarchy measurements from Level 2 to Level 3 and
that bank profits might increase by as much as 20
percent.
However, as noted earlier in Chapter 1, a subsequent
study of the impact of the adoption of FSP FAS 157-4 on
seventy-three of the largest banks in the United States
found that a large majority of the banks reported that
adoption of the new requirements had no material impact
Proposed Format of Statement of
Financial Position
FASB-IASB Project (Phase B)
Groups assets and liabilities together
Operating
Investing
Financing
Provides separate section
for stockholders equity
Evaluating A Companys Financial Position

Return on Assets
Net income
Average total assets
Profit margin
Net income
Net sales
Asset turnover ratio
Net sales
Average total assets
Hershey & Tootsie Roll Return on Assets
Hershey
2011 2010
$628,962 $509,799
($4,412,199 + 4,272,732)/2 ($4,272,732 + 3,675,031)/2
=14.48% =12.83%

Tootsie Roll
2011 2010
$43,938 $53,063
($857,856 + 857,959)/2 ($857,959 + 838,247)/2
=5.12% =6.26%
Hershey and Tootsie: Return on Assets

Return on Assets

16.00% 14.48%
12.83%
14.00%
12.00%
10.00%
8.00% 6.26%
5.12%
6.00%
4.00%
2.00%
0.00%
2010 2011

Hershey Tootsie Roll

Hershey & Tootsie Roll Other Ratios
2011

Hershey Tootsie Roll

Profit margin 11.25% 8.33%
Asset turnover 1.40 0.62
 Evolution of the Statement
of Cash Flows
Prior to 1971
Only two required
financial statements
Firms were preparing funds
statements
No guidelines - Methods of preparing statement:
1 Cash
2 Working capital
3 All financial resources
APB No. 3 - recommended
APB No. 19 - mandatory - all financial resources
 APB Opinions 3 and 19
Designed to answer the following questions
1 Where did the profits go?
2 Why werent dividends larger?
3 How was it possible to distribute dividends
in the presence of a loss?
4 Why are current assets down when there was a profit?
5 Why is extra financing required?
6 How was the expansion financed?
7 Where did the funds from the sale of securities go?
8 How was the debt retirement accomplished?
9 How was the increase in working capital financed?
 Cash Flow Information
Should enable financial statement
users to
Predict the amount of cash that is likely to be
distributed as dividends or interest
Evaluate risk
Presentation of cash flow information assists in
evaluating
Liquidity
Nearness to cash
Solvency
Going concern
Financial flexibility
React to crisis
 Historical Perspective
Discussion memorandum
Reporting Funds Flows, Liquidity, and Financial Flexibility
Preceded the issuance of SFAS No. 95
Questions raised in this DM included:
1. Which concept of funds should be adopted?
2. How should transactions not having a direct impact on funds be
reported?
3. Which of the various approaches should be used for presenting
funds flow information?
4. How should information about funds flow from operations be
presented?
5. Should funds flow information be separated into outflows for
(a) Maintenance
(b) Expansion of operating capacity, and
(c) Nonoperating purposes
 Historical Perspective
Exposure Draft
Reporting Income, Cash Flows and Financial
Position of Business Enterprises
SFAC No. 5
Recognition and
Measurement in Financial
Statements of Business
Enterprises
 Purpose of the Statement of
Cash Flows
Provide relevant information about
cash receipts and cash payments of
an enterprise

Objectives of accounting originally discussed

in SFAC Nos. 1 and 5 led to conclusion
Statement of cash flows should replace the
previously required statement of changes in
financial position
 Statement Format
Report changes during an accounting
period in cash and cash equivalents for
Net cash flows from operations
Investing transactions
Financing transactions
Fiscal 2011:
Hershey had a net decrease in cash of
$190,956,000
Tootsie Roll had a net decrease in cash of
$37,364,000
Cash Flows From Operating Activities
Cash effect from transactions
that enter into the determination
of net income
exclusive of financing and investing activities
Direct vs Indirect method
SFAS No. 95
Encouraged companies to report
operating activities in major classes
Hershey vs Tootsie Roll 2011
Hershey $580,867,000
Tootsie $50,390,000
Cash Flows From Investing Activities

Making and collecting loans

Acquiring and disposing of debt
or equity securities of other companies
Acquiring and disposing of property, plant,
and equipment and other productive
resources
Hershey vs Tootsie Roll 2011
Hershey ($333,005,000)
Tootsie Roll ($51,157,000)
Cash Flows From Financing Activities
Results from
Obtaining resources from owners
Providing owners with a return
of and a return on their investment
Borrowing money and repaying
the amount borrowed
Obtaining and paying for other resources
from long-term creditors
Hershey vs Tootsie Roll 2011
Hershey ($438,818,000)
Tootsie ($36,597,000)
Proposed Format of Statement of Cash Flows

Phase B of FASB-IASB Presentation Project

Expanded version of direct method
Additional disclosures for each category
New schedule, in notes, to reconcile cash
flows to operating income
Proposed Format of Statement of Cash Flows

Categories:
Business
Operating
Investing
Financing
Income Taxes
Discontinued Operations
Equity
Financial Analysis of Cash Flow Information
A major objective of accounting
To provide data allowing the presentation of cash
flows to investors and creditors
To allow evaluation of risk
Net income is not directly
associated with cash
Investors expect return equal to
market rate of interest for investments with
equal risk

discounted future cash flows > investment

 Uses of Cash Flow Information
Past cash flows are the best indicators of future cash
flows
Empirical research indicates cash flow information
Has an incremental value over earnings
And is superior to disclosure of changes in working capital
 Uses of Cash Flow Information
Net cash provided (used) from operating activities
-Net cash used in acquiring PP&E

Free Cash Flow

Indicator of a companys ability to pay off debt & maintain growth.

Free Cash Flows
Hershey Tootsie Roll
2010 2011 2010 2011
$721,855 $256,906 $69,492 $34,039

(in thousands)

Hershey remained positive but metric

deteriorated
Tootsie Roll was also positive in both
years but deteriorated from 2010 to
2011
 International Accounting Standards

The IASB has discussed:

1 The statement of financial position
and the various measurement bases used in accounting
Defined assets, liabilities and equity in Framework for the
Preparation and Presentation of Financial Statements
2 The information to be disclosed on the balance sheet and
statement of cash flows in a revised IAS No. 1
3 The presentation of the statement of cash flows in IAS No. 7,
Cash Flow Statements
3 Discussed the presentation of fair value measurements in
IFRS No. 13, Fair Value Measurement
 Preparation and Presentation of
Financial Statements
Economic decisions made by users require an evaluation of the ability of
an enterprise to generate cash
Financial position of an enterprise is affected by its
Financial structure

Liquidity and solvency

Capacity to adapt to change (financial flexibility)

Measurement bases include

Historical cost (most common)

Current cost

Realizable value

Present value

Definitions of assets, liabilities and equity are similar to

U. S. GAAP
 IAS No. 1: Presentation of
Financial Statements
Recommends disclosures similar
to U. S. GAAP
Revised IAS No. 1
Requires assets to be classified as current and noncurrent
Unless a liquidity presentation provides more relevant and reliable
information
Recognizes that there are differences in the nature and function of
assets, liabilities, and equity
So fundamental that they should be presented on the face of the
balance sheet.
Specifies specific categories of items to be disclosed
IAS No. 7
Operating, financing and investing
activities are to be disclosed
Indirect or direct method of disclosing
operating activities may be used
Stated a preference for the direct method.
Cash flows from extraordinary items
required to be disclosed separately as
operating, investing or financing.
Acquisition or disposal of subsidiaries
Will significantly change presentation of
statement of cash flows.
 IFRS No. 13
Applies to IFRSs that require or permit fair value
measurements or disclosures
IFRS No. 13 achieves convergence with U. S.
GAAP. Specifically, it:
Defines fair value
Provides framework for measuring fair value
Requires disclosures about fair value measurements
Attempts to provide consistency and comparability
in fair value measurements and related
disclosures.
IFRS No. 13: Fair Value Hierarchy

Level 1 inputs
Quoted prices in active markets for identical assets or
liabilities
Level 2 inputs
Inputs other than quoted market prices that are observable
for the assets or liability
Level 3 inputs
Unobservable inputs for the asset or liability Level 3

Level 2

Level 1
 End of Chapter 7

Prepared by Kathryn Yarbrough, MBA

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