Accounting: The Language of Business - Vol. 2 (Intermediate: Part 64)

As the titanic losses were racking up, Fannie Mae's operators, Franklin Raines and Jamie Gorelick, disguised the catastrophe by orchestrating a $5 billion accounting fraud - all the while continuing to pressure banks to make absurd, politically correct loans and denouncing Republicans as enemies of the poor.

Ann Coulter

Statements of Financial Position and Cash Flows and the Annual Report (Part B)

by

Charles Lamson

The Statement of Financial Position

The statement of financial position, also called the balance sheet, lists an entity's assets, liabilities, and equity as of a specific point in time. The terms statement of financial position and balance sheet are used interchangeably in the next several parts of this analysis. The balance sheet consists of permanent accounts with cumulative balances that the company carries forward period-to-period over the life of the firm. As noted in Part 34, permanent accounts are not closed at year end.

THE CONCEPTUAL FRAMEWORK:

Usefulness and Limitations of the Balance Sheet

The balance sheet provides critical information to financial statement users in three key areas. Specifically, the balance sheet:

1. Summarizes the economic resources and obligations that impact the entity's ability to generate future cash flows.

2. Is useful in assessing an entity's rate of return on its investments when examined in conjunction with the income statement.

3. Aids in assessing the risk associated with an entity by providing inputs for cash flow measures.

Three common cash flow measures based on balance sheet information are liquidity, solvency, and financial flexibility. Liquidity is a measure of an asset's nearness to cash---that is, how quickly the firm can convert assets into cash and pay liabilities with minimal risk of loss. Analyzing an entity's liquidity allows investors to determine whether it will have the resources needed to pay its currently maturing obligations, pay dividends, and/or buy back its own equity shares. Thus, the more liquid an entity, the lower the risk associated with that entity.

 Solvency is a measure of a firm's long-term ability to pay its obligations as they mature. A firm with a high level of debt relative to its equity may have difficulty meeting the fixed payments associated with its debt and therefore is in a positive position of low solvency. We discuss various financial ratios that are used to measure liquidity and solvency in an upcoming post.

Financial flexibility indicates an entity's ability to respond to unexpected needs and opportunities by taking actions that alter the amounts and timing of cash flows. For example, expanding into international markets may require additional debt financing. An entity with low levels of debt on its balance sheet can borrow the funds needed to finance this expansion. The greater an entity's financial flexibility, the lower its risk.

Whereas the statement of financial position provides a number of benefits, financial statement users also realize that the statement has certain limitations related to the following issues.

• Many of the accounts on the balance sheet are reported at historical cost as opposed to market values or liquidation values. For example, assume an entity purchased land 10 years ago for $1,000 that now has a market value of $10,000. The firm reports the asset on the balance sheet under U.S. GAAP at the historical cost of $1,000. In this way, relying on historical costs limits the relevance of information on the balance sheet.

• A number of assets and liabilities are not reported on the balance sheet. For example, assets such as human capital and a company's reputation for quality products will not be reported on the balance sheet.

• Many of the accounts reported on the balance sheet are based on estimates as opposed to determinable amounts. For example, the net realizable value of accounts receivable is based on the estimated amount of cash that the entity expects to collect.

Balance Sheet Classifications

The primary classifications on the balance sheet are assets, liabilities, and stockholders' equity. The balance sheet utilizes subclassifications within each of these broad groups that enhance the usefulness of the balance sheet by grouping the accounts according to characteristics such as nature, or size. One of the primary distinctions is current versus non-current. Non-current assets are resources that the firm expects to convert to cash, use, or consume in a period of more than one year or one reporting cycle, whichever is longer. Non-current liabilities are obligations that are due after one year or one operating cycle, whichever is longer. Exhibit 6.1 presents the typical groupings used to subdivide those categories, We discuss each of these subclassifications in more detail in the following parts of this analysis.

  EXHIBIT 6.1 Balance Sheet Classifications

Managers make several decisions related to how to report, or format, the classifications in Exhibit 6.1 on the balance sheet. The reporting options include:

• Aggregating and summarizing accounts into financial statement components or line items. For example, a company could have several accounts for property, plant, and equipment in its general ledger that it aggregates and summarizes in a single line item called “Property, plant, and equipment.”

• Grouping or classifying the components. Specifically, assets and liabilities can be grouped or classified as current and non-current.

• Providing subtotals, and totals. Subtotals often relate to how items are grouped. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED. PP. 236-237*

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