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Chapter 5

MGAC01H3 Chapter Notes - Chapter 5: Cash Flow, Financial Statement, Historical Cost

Financial Accounting
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Chapter 5 Financial Position and Cash Flows Notes
Section 1—Balance Sheet
Usefulness of the Balance Sheet
the balance sheet is useful for analyzing a company’s liquidity, solvency, and financial flexibility, and helps also in analyzing
profitability (even though this is not the main focus of the statement)
liquidity looks at the amount of time that is expected to pass until an asset is realized or until a liability has to be paid
creditors are interested in short-term liquidity ratios, because they indicate whether the firm will have resources to pay its current and
maturing obligations, and shareholders assess liquidity to evaluate the possibility of future cash dividends or the buyback of shares
solvency refers to an enterprise’s ability to pay its debt and related interest
liquidity and solvency affect an entity’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”
Limitations of the Balance Sheet
some of the major limitations of the balance sheet are:
1) Many assets and liabilities are stated at their historical cost. As a result, the information that is reported in the balance sheet has
higher reliability but it can be criticized as being less relevant than the current fair value would be.
2) Judgments and estimates are used in determining many of the items reported in the balance sheet.
3) The balance sheet necessarily leaves out many items that are of relevance to the business but cannot be recorded objectively.
These may be either assets or liabilities. Because liquidity and solvency ratios worsen when liabilities are recognized, a
company may be biased against including liabilities in the financial statements. Knowing this, analysts habitually look for and
capitalize many liabilities that may be “off-balance sheet” before they calculate key liquidity and solvency ratios.
Additional Information Reported
a contingency is an existing situation in which there is uncertainty about whether a gain or loss will occur and that will finally be
resolved when one or more future events occur or fail to occur
sometimes rights or obligations have 2 parts: unconditional right/obligation (a “stand ready” right/obligation) and conditional one
the unconditional right/obligation is recognized as long as it meets the definition of an asset/obligation
the conditional right/obligation is normally contingent upon some future event occurring or not
this uncertainty is taken into account through measurement of the asset/obligation
Accounting Policies
accounting standards recommend disclosure for all significant accounting principles and methods that management has chosen from
among alternatives or that are peculiar to a particular industry, such as costing of inventory, depreciation, and investment valuation
users of financial statements who are more informed know of these possibilities and examine the statements closely to determine the
methods that are used and their impact on net income and key ratios
Subsequent Events
notes to the financial statements should explain any significant financial events that occur after the formal balance sheet date but
before the financial statements have been issued
subsequent events fall into 2 types or categories:
1) events that provide further evidence of conditions that existed at the balance sheet date (financial statements must be adjusted)
2) events that indicate conditions that occurred after the financial statement date (these must be disclosed in notes if the condition
causes a significant change to assets or liabilities, and/or it will have a significant impact on future operations)
Section 2—Statement of Cash Flows
Purpose of the Statement of Cash Flows
main purpose is to allow users to assess enterprise’s capacity to generate cash and cash equivalents and its needs for cash resources
reporting the sources, uses, and net increase or decrease in cash helps investors, creditors, and others know what is happening to cash
because most people maintain their chequebook and prepare their tax return on a cash basis, they can relate to and understand the
statement of cash flows as it shows the causes and effects of cash inflows and outflows and the net increase or decrease in cash
Content and Format of the Statement of Cash Flows
the classifications are defined as follows:
1) operating activities are main revenue-producing activities and all other activities that are not related to investing or financing
2) investing activities are acquisitions and disposals of long-term assets and other investments not included in cash equivalents
3) financing activities are activities that result in changes in size and composition of enterprise’s equity capital and borrowings
Summary of Learning Objectives
1. Identify the uses and limitations of a balance sheet.
The balance sheet provides information about the nature and amounts of investments in enterprise resources, obligations to creditors,
and the owners’ equity in net resources. The balance sheet contributes to financial reporting by providing a basis for (1) calculating
rates of return, (2) evaluating the enterprise’s capital structure, and (3) assessing the enterprise’s liquidity, solvency, and financial
flexibility. The limitations of a balance sheet are as follows: (1) The balance sheet often does not reflect current value, because
accountants have adopted a historical cost basis in valuing and reporting many assets and liabilities. (2) Judgments and estimates
must be used in preparing a balance sheet. The collectability of receivables, the saleability of inventory, and the useful life of long-
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