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PART II: Corporate Accounting Concepts and Issues

Lecture 07

Practical Issues related to


Balance Sheet and
Statement of Cash Flow

Instructor
Adnan Shoaib
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Learning
Learning Objectives
Objectives

1.

Explain the uses and limitations of a balance sheet.

2.

Identify the major classifications of the balance sheet.

3.

Prepare a classified balance sheet using the report and account


formats.

4.

Indicate the purpose of the statement of cash flows.

5.

Identify the content of the statement of cash flows.

6.

Prepare a statement of cash flows.

7.

Understand the usefulness of the statement of cash flows.

8.

Determine which balance sheet information requires supplemental


disclosure.

9.

Describe the major disclosure techniques for the balance sheet.

Balance
Balance Sheet
Sheet and
and Statement
Statement of
of Cash
Cash Flows
Flows

Balance Sheet

Statement of
Cash Flows

Usefulness

Purpose

Limitations

Content and format

Classification

Preparation
Usefulness

Additional
Information
Supplemental
disclosures
Techniques of
disclosure

Balance
Balance Sheet
Sheet
Balance Sheet, also referred to as the statement of
financial position:
1. Reports assets, liabilities, and equity at a specific date.
2. Provides information about resources, obligations to
creditors, and equity in net resources.
3. Helps in predicting amounts, timing, and uncertainty of
future cash flows.

LO 1 Explain the uses and limitations of a balance sheet.

Balance
Balance Sheet
Sheet
Usefulness of the Balance Sheet

Computing rates of return.

Evaluating the capital structure.

Assess risk and future cash flows.

Analyze the companys:

Liquidity,

Solvency, and

Financial flexibility.
LO 1 Explain the uses and limitations of a balance sheet.

Balance
Balance Sheet
Sheet
Limitations of the Balance Sheet

Most assets and liabilities are reported at historical


cost.

Use of judgments and estimates.

Many items of financial value are omitted.

LO 1 Explain the uses and limitations of a balance sheet.

Balance
Balance Sheet
Sheet
Classification

LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet
Classification
Illustration 5-1

In practice you usually see little departure from these major subdivisions.

LO 2 Identify the major classifications of the balance sheet.

Classification
Classification in
in the
the Balance
Balance Sheet
Sheet
Current Assets
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.
Illustration 5-2

LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Current
Current Assets
Assets
Cash

Generally any monies available on demand.

Cash equivalents - short-term highly liquid investments


that mature within three months or less.

Restrictions or commitments must be disclosed.


Illustration 5-3

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LO 2

Balance
Balance Sheet
Sheet Current
Current Assets
Assets
Cash
Illustration 5-4
Balance SheetRestricted Cash

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LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Current
Current Assets
Assets
Short-Term Investments

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Portfolios

Type

Valuation

Classification

Held-toMaturity

Debt

Amortized
Cost

Current or
Noncurrent

Trading

Debt or
Equity

Fair Value

Current

Availablefor-Sale

Debt or
Equity

Fair Value

Current or
Noncurrent

LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Current
Current Assets
Assets
Short-Term Investments
Illustration 5-5
Balance Sheet Presentation of
Investments in Securities

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LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Current
Current Assets
Assets
Receivables
Major categories of receivables should be shown in the
balance sheet or the related notes.
A company should clearly identify

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Anticipated loss due to uncollectibles.

Amount and nature of any nontrade receivables.

Receivables used as collateral.

LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Current
Current Assets
Assets
Receivables
Illustration 5-6
Balance Sheet Presentation
of Receivables

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LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Current
Current Assets
Assets
Inventories
Disclose:

Basis of valuation (e.g., lower-of-cost-or-market).

Cost flow assumption (e.g., FIFO or average cost).


Illustration 5-6

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LO 2

Balance
Balance Sheet
Sheet Current
Current Assets
Assets
Prepaid Expenses
Payment of cash, that is recorded as an asset because
service or benefit will be received in the future.

Cash Payment

BEFORE

Expense Recorded

Prepayments often occur in regard to:

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insurance

rent

supplies

taxes

advertising
LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Current
Current Assets
Assets
Prepaid Expenses
Illustration 5-9

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LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Current
Current Assets
Assets
Current Assets - Summary
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.
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LO 2 Identify the major classifications of the balance sheet.

Classification
Classification in
in the
the Balance
Balance Sheet
Sheet
Non-Current Assets
Long-term Investments
1. Securities (bonds, common stock, or long-term notes).
2. Tangible fixed assets not currently used in operations
(land held for speculation).
3. Special funds (sinking fund, pension fund, or plant
expansion fund.
4. Non-consolidated subsidiaries or affilated companies.

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LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Noncurrent
Noncurrent Assets
Assets
Long-Term Investments
Portfolios

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Type

Valuation

Classification

Held-toMaturity

Debt

Amortized
Cost

Current or
Noncurrent

Trading

Debt or
Equity

Fair Value

Current

Availablefor-Sale

Debt or
Equity

Fair Value

Current or
Noncurrent

LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Noncurrent
Noncurrent Assets
Assets
Long-Term
Investments
Securities

bonds,

stock, and

long-term notes

For marketable securities,


managements intent
determines current or
noncurrent classification.
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LO 2

Balance
Balance Sheet
Sheet Noncurrent
Noncurrent Assets
Assets
Long-Term
Investments
Fixed Assets

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Land held for


speculation

LO 2

Balance
Balance Sheet
Sheet Noncurrent
Noncurrent Assets
Assets
Long-Term
Investments
Special Funds

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Sinking fund

Pensions fund

Cash surrender
value of life
insurance

LO 2

Balance
Balance Sheet
Sheet Noncurrent
Noncurrent Assets
Assets
Long-Term
Investments

Nonconsolidated
Nonconsolidated
Subsidiaries
Subsidiaries or
or
Affiliated
Companies
Companies
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LO 2

Balance
Balance Sheet
Sheet Noncurrent
Noncurrent Assets
Assets
Long-Term Investments
Illustration 5-10
Balance Sheet
Presentation of
Long-Term Investments

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LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Noncurrent
Noncurrent Assets
Assets
Property, Plant, and Equipment
Tangible long-lived assets used in the regular operations
of the business.

Physical property such as land, buildings, machinery,


furniture, tools, and wasting resources (minerals).

With the exception of land, a company either depreciates


(e.g., buildings) or depletes (e.g., oil reserves) these
assets.

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LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Noncurrent
Noncurrent Assets
Assets
Property, Plant, and
Equipment
Tangible assets used
in the regular
operations of the
business.

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LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Noncurrent
Noncurrent Assets
Assets
Illustration 5-11
Balance Sheet Presentation of
Property, Plant, and Equipment

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LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Noncurrent
Noncurrent Assets
Assets
Intangibles
Lack physical substance
and are not financial
instruments.

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Limited life intangibles


amortized.

Indefinite-life
intangibles tested for
impairment.

LO 2

Balance
Balance Sheet
Sheet Noncurrent
Noncurrent Assets
Assets
Intangibles (BE5-6): Patrick Corporation adjusted trial balance
contained the following asset accounts at December 31, 2012: Prepaid
Rent $12,000; Goodwill $50,000; Franchise Fees Receivable $2,000;
Franchises $47,000; Patents $33,000; Trademarks $10,000. Prepare
the intangible assets section of the balance sheet.
Intangibles
Goodwill
Franchises

47,000

Patents

33,000

Trademarks

10,000

Total
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$ 50,000

$140,000

LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Noncurrent
Noncurrent Assets
Assets
Intangible Assets
Illustration 5-12
Balance Sheet
Presentation of
Intangible Assets

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LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Noncurrent
Noncurrent Assets
Assets
Other Assets
Items vary in practice. Can include:

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Long-term prepaid expenses

Non-current receivables

Assets in special funds

Property held for sale

Restricted cash or securities

LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Noncurrent
Noncurrent Assets
Assets
Other Assets
This section should
include only unusual items
sufficiently different from
assets in the other
categories.

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LO 2

Classification
Classification in
in the
the Balance
Balance Sheet
Sheet
Current Liabilities
Obligations that a
company reasonably
expects to liquidate either
through the use of current
assets or the creation of
other current liabilities.

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LO 2 Identify the major classifications of the balance sheet.

Classification
Classification in
in the
the Balance
Balance Sheet
Sheet
Current Liabilities
Illustration 5-13
Balance Sheet Presentation
of Current Liabilities

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LO 2 Identify the major classifications of the balance sheet.

Classification
Classification in
in the
the Balance
Balance Sheet
Sheet
Long-Term Liabilities
Obligations that a
company does not
reasonably expect to
liquidate within the normal
operating cycle.
All covenants and
restrictions must be
disclosed.
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LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Long-Term
Long-Term Liabilities
Liabilities
Long-Term Liabilities (BE5-9): Included in Adams Companys
December 31, 2012, trial balance are the following accounts: Accounts
Payable $220,000; Pension Asset/Liability $375,000; Discount on
Bonds Payable $29,000; Unearned Revenue $41,000; Bonds Payable
$400,000; Salaries and Wages Payable $27,000; Interest Payable
$12,000; Income Taxes Payable $29,000. Prepare the long-term
liabilities section of the balance sheet.
Long-term liabilities
Pension Asset/liability
Bonds payable
Discount on bonds payable
Total
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$375,000
400,000
(29,000)
746,000

LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Long-Term
Long-Term Liabilities
Liabilities
Non-Current Liabilities
Illustration 5-14
Balance Sheet Presentation
of Non-Current Liabilities

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LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Owners
Owners Equity
Equity
Owners Equity

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LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Owners
Owners Equity
Equity
Owners Equity
Illustration 5-15
Balance Sheet Presentation
of Stockholders Equity

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LO 2 Identify the major classifications of the balance sheet.

Classification
Classification in
in the
the Balance
Balance Sheet
Sheet
Account

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Classification

(a) Investment in preferred stock

(a) Current asset/Investment

(b) Treasury stock

(b) Stockholders Equity

(c) Common stock

(c) Stockholders Equity

(d) Cash dividends payable

(d) Current liability

(e) Accumulated depreciation

(e) Contra-asset

(f) Interest payable

(f) Current liability

(g) Deficit

(g) Stockholders Equity

(h) Trading securities

(h) Current asset

(i) Unearned revenue

(i) Current liability

LO 2 Identify the major classifications of the balance sheet.

Balance
Balance Sheet
Sheet Format
Format
Classified Balance Sheet

Account form

Report form

Accounting Trends and Techniques2009 (New York:


AICPA) indicates that all of the 500 companies surveyed
use either the report form (438) or the account form (62),
sometimes collectively referred to as the customary form.

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LO 3 Prepare a classified balance sheet using the report and account formats.

Balance
Balance Sheet
Sheet Format
Format
Account Form

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Illustration 5-16

LO 3 Prepare a classified balance sheet using the report and account formats.

Balance
Balance Sheet
Sheet
Format
Format

Report Form

Illustration 5-16
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LO 3

U.
U. S.
S. GAAP
GAAP vs.
vs. IFRS
IFRS
There are more similarities than differences in balance sheets
prepared according to U.S. GAAP and those prepared applying
IFRS.
Some difference are highlighted below.

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Does not specify a minimum


list of items to be presented in
the balance sheet.
Some U.S. companies use the
statement of financial position
title as well.
Presents current assets and
liabilities before noncurrent
assets and liabilities.

Specifies a minimum list of


items to be presented in the
balance sheet.
Statement title changed to
statement of financial
position.
Does not prescribe the format
of the balance sheet, but
balance sheets prepared using
IFRS often report noncurrent
items first.

U.
U. S.
S. GAAP
GAAP vs.
vs. IFRS
IFRS

The FASB and IASB are working together on the Financial


Statement Presentation project to establish a common standard
for presenting information in the financial statements.

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Each of the financial


statements will include
classifications by operating,
investing, and financing
activities, as well as income
taxes, discontinued
operations, and equity (if
needed).

Statement
Statement of
of Cash
Cash Flows
Flows
One of the three basic objectives of financial
reporting is

assessing the amounts, timing, and


uncertainty of cash flows.

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LO 4 Indicate the purpose of the statement of cash flows.

Statement
Statement of
of Cash
Cash Flows
Flows
Purpose of the Statement of Cash Flows
To provide relevant information about the cash receipts
and cash payments of an enterprise during a period.
The statement provides answers to the following
questions:

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1.

Where did the cash come from?

2.

What was the cash used for?

3.

What was the change in the cash balance?


LO 4 Indicate the purpose of the statement of cash flows.

Statement
Statement of
of Cash
Cash Flows
Flows
Content and Format
Three different activities:

Operating,

Investing,

Financing

Illustration 5-17
Basic Format of Cash
Flow Statement

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LO 5 Identify the content of the statement of cash flows.

Statement
Statement of
of Cash
Cash Flows
Flows
Content and Format
Operating

Investing

Financing

Cash inflows and


outflows that
enter into the
determination of
net income.

Cash inflows and


outflows from
non-current
assets.

Cash inflows and


outflows from
non-current
liabilities and
equity.

The statements value is that it helps users evaluate liquidity, solvency,


and financial flexibility.
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LO 5 Identify the content of the statement of cash flows.

Statement
Statement of
of Cash
Cash Flows
Flows
Illustration 5-18

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LO 5 Identify the content of the statement of cash flows.

Direct
Direct and
and Indirect
Indirect Methods
Methods of
of Reporting
Reporting
Two Formats for Reporting Operating Activities

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Direct Method

Indirect Method

Reports the
cash effects of
each operating
activity

Starts with
accrual net
income and
converts to
cash basis

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Direct
Direct Method
Method
Under the direct method, the cash effect of each
operating activity is reported directly in the statement.

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Indirect
Indirect Method
Method
By the indirect method, we arrive at net cash flow from operating
activities indirectly by starting with reported net income and
working backwards to convert that amount to a cash basis.

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Preparation
Preparation of
of the
the Statement
Statement of
of Cash
Cash Flows
Flows
Sources of Information
Information obtained from several sources:
(1) comparative balance sheets,
(2) the current income statement, and
(3) selected transaction data.

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LO 6 Prepare a basic statement of cash flows.

Statement
Statement of
of Cash
Cash Flows
Flows
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 telecommunications
equipment and performed marketing services throughout the
first year. In June 2012 the company purchased land for
$15,000. Illustration 5-19 shows the companys comparative
balance sheets at the beginning and end of 2012.

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LO 6 Prepare a basic statement of cash flows.

Statement
Statement of
of Cash
Cash Flows
Flows
Illustration 5-19

Illustration 5-20

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LO 6

Statement
Statement of
of Cash
Cash Flows
Flows
Preparing the Statement of Cash Flows
Determine:
1. Cash provided by (or used in) operating activities.
2. 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.
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LO 6 Prepare a basic statement of cash flows.

Statement
Statement of
of Cash
Cash Flows
Flows
Illustration 5-19
Illustration 5-20

Cash provided by operating activities

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Illustration 5-21

LO 6 Prepare a basic statement of cash flows.

Illustration 5-19
Illustration 5-20

Statement
Statement of
of
Cash
Cash Flows
Flows
Next, the company
determines its investing
and financing activities.

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Illustration 5-21

Statement
Statement of
of Cash
Cash Flows
Flows
Statement of Cash Flows (BE 5-12): Keyser Beverage
Company reported the following items in the most recent year.
Activity
Net income
Dividends paid
Increase in accounts receivable
Increase in accounts payable
Purchase of equipment
Depreciation expense
Issue of notes payable

$40,000
5,000
10,000
7,000
8,000
4,000
20,000

Operating
Financing

Operating
Operating
Investing
Operating
Financing

Required: Compute net cash provided by operating activities.


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LO 6 Prepare a basic statement of cash flows.

Statement
Statement of
of Cash
Cash Flows
Flows
Statement of Cash Flows (BE 5-12)
Noncash credit to
revenues.
Noncash charge to
expenses.

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LO 6 Prepare a basic statement of cash flows.

Statement
Statement of
of Cash
Cash Flows
Flows
Review
In preparing a statement of cash flows, which of the following
transactions would be considered an investing activity?

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a.

Sale of equipment at book value

b.

Sale of merchandise on credit

c.

Declaration of a cash dividend

d.

Issuance of bonds payable at a discount receivable.

LO 6 Prepare a basic statement of cash flows.

Statement
Statement of
of Cash
Cash Flows
Flows
Significant Noncash Activities
Significant financing and investing activities that do not
affect cash are reported in either a separate schedule at
the bottom of the statement of cash flows or in the notes.
Examples include:

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Issuance of common stock to purchase assets.

Conversion of bonds into common stock.

Issuance of debt to purchase assets.

Exchanges on long-lived assets.


LO 6 Prepare a basic statement of cash flows.

Statement
Statement of
of Cash
Cash Flows
Flows

Illustration 5-23
Comprehensive
Statement of Cash Flows

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U.
U. S.
S. GAAP
GAAP vs.
vs. IFRS
IFRS
Like U.S. GAAP, international standards also require a statement of
cash flows. Consistent with U.S. GAAP, cash flows are classified
as operating, investing, or financing.

Typical Classification of Cash Flows from


Interest and Dividends

Operating Activities

Dividends Received
Interest Received
Interest Paid

Operating Activities

Investing Activities

Investing Activities

Financing Activities

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Dividends Paid

Dividends Received
Interest Received

Financing Activities

Dividends Paid
Interest Paid

U.
U. S.
S. GAAP
GAAP vs.
vs. IFRS
IFRS
The FASB and IASB are working together on a project, Financial
Statement Presentation, to establish a common standard for
presenting information in the financial statements.

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Usefulness
Usefulness of
of the
the Statement
Statement of
of Cash
Cash Flows
Flows
Without cash, a company will not survive.
Cash flow from Operations:

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High amount - company able to generate sufficient


cash to pay its bills.

Low amount - company may have to borrow or issue


equity securities to pay bills.

LO 7 Understand the usefulness of the statement of cash flows.

Usefulness
Usefulness of
of the
the Statement
Statement of
of Cash
Cash Flows
Flows
Financial Liquidity
Current Cash
Debt Coverage
Ratio

Net Cash Provided by


Operating Activities
=

Average Current Liabilities

Ratio indicates whether the company can pay off its current
liabilities from its operations. A ratio near 1:1 is good.

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LO 7 Understand the usefulness of the statement of cash flows.

Usefulness
Usefulness of
of the
the Statement
Statement of
of Cash
Cash Flows
Flows
Financial Liquidity
Cash Debt
Coverage
Ratio

Net Cash Provided by


Operating Activities
=

Average Total Liabilities

This ratio indicates a companys ability to repay its liabilities


from net cash provided by operating activities, without having
to liquidate the assets employed in its operations.

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LO 7 Understand the usefulness of the statement of cash flows.

Usefulness
Usefulness of
of the
the Statement
Statement of
of Cash
Cash Flows
Flows
Free Cash Flow
Illustration 5-28

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.
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LO 7 Understand the usefulness of the statement of cash flows.

Usefulness
Usefulness of
of the
the Statement
Statement of
of Cash
Cash Flows
Flows
Review
The current cash debt coverage ratio is often used to assess
a. financial flexibility.
b. liquidity.
c. profitability.
d. solvency.

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LO 7 Understand the usefulness of the statement of cash flows.

Supplemental
Supplemental Disclosures
Disclosures
Four types of information that are supplemental to account
titles and amounts presented in the balance sheet:

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LO 8 Determine which balance sheet information


requires supplemental disclosure.

Techniques
Techniques of
of Disclosure
Disclosure

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Parenthetical Explanations

Notes

Cross-Reference and Contra Items

Supporting Schedules

Terminology

LO 9 Describe the major disclosure techniques for the balance sheet.

RELEVANT FACTS

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IFRS recommends but does not require the use of the title
statement of financial position rather than balance sheet.

IFRS requires a classified statement of financial position except in


very limited situations. IFRS follows the same guidelines as this
textbook for distinguishing between current and noncurrent assets
and liabilities. However under GAAP, public companies must follow
SEC regulations, which require specific line items. In addition,
specific GAAP standards mandate certain forms of reporting this
information.

Under IFRS, current assets are usually listed in the reverse order of
liquidity. For example, under GAAP cash is listed first, but under
IFRS it is listed last.

RELEVANT FACTS

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IFRS has many differences in terminology that you will notice in this
textbook.

Both IFRS and GAAP require disclosures about (1) accounting


policies followed, (2) judgments that management has made in the
process of applying the entitys accounting policies, and (3) the key
assumptions and estimation uncertainty that could result in a
material adjustment to the carrying amounts of assets and liabilities
within the next financial year. Comparative prior period information
must be presented and financial statements must be prepared
annually.

Use of the term reserve is discouraged in GAAP, but there is no


such prohibition in IFRS.

End
End of
of Lecture
Lecture 07
07

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