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Chapter 6
Understanding Cash Flow Statements
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Customization notes:
The third section of this presentation shows a simple example of
how to prepare a statement of cash flows. Depending on the
sophistication of the audience, that section can either be deleted
(if the audience is already proficient in preparing the statement
of cash flows) or expanded to include more complex examples
(if the presenter wants to emphasize statement preparation and
has additional time for the presentation).
LEARNING OUTCOMES
Compare cash flows from operating, investing, and financing
activities and classify cash flow items as relating to one of

those three categories given a description of the items.
Describe how non-cash investing and financing activities are
reported.
Contrast cash flow statements prepared under International
Financial Reporting Standards (IFRS) and U.S. generally
accepted accounting principles (U.S. GAAP).
Distinguish between the direct and indirect methods of
presenting cash from operating activities and describe the
arguments in favor of each method.
Describe how the cash flow statement is linked to the income
statement and the balance sheet.
Describe the steps in the preparation of direct and indirect cash
flow statements, including how cash flows can be computed
using income statement and balance sheet data.
Convert cash flows from the indirect to direct method.
Analyze and interpret both reported and common-size cash flow
statements.
Calculate and interpret free cash flow to the firm, free cash flow
to equity, and performance and coverage cash flow ratios.
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overview
Statement of Cash Flows: Overview
Format of Statement of Cash Flows
Preparing a Statement of Cash Flows
Additional Analytical Considerations
Copyright © 2013 CFA Institute
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2
3

LOS. Describe how the cash flow statement is linked to the
income statement and the balance sheet.
LOS. Analyze and interpret both reported and common-size cash
flow statements.
The cash flow statement provides information about a
company’s cash receipts and cash payments during an
accounting period.
Starting at the bottom of the statement of cash flows, we see the
increase and decrease in cash and cash equivalents each year.
Increase (decrease) in cash (in millions)
2011 388
2010 (110)
2009 45
An overall $323 million net increase in cash over three years,
from $555 million at the beginning of 2009 to $878 million at
the end of 2011.
In general, what are the implications of too little cash? Too
much?
3
4
APPLE, Inc.
flow statements.

As a basis for comparison—and relating to the question of how
much cash is enough/too much on the previous slide—this slide
shows the statement of cash flows for Apple.
In 2010, for example, Apple’s cash and cash equivalents
increased by $6 billion to $11.3 billion. Apple generated $18.6
billion from operating activities and needed only around $3
billion for expenditures on PP&E (property, plant, and
equipment), intangible assets, and acquisitions. Apple paid no
dividends. Even after $11 billion of net purchases of marketable
securities (net purchases were $57,793 billion – $24,930 billion
from maturities – $21,788 billion from sales), the company still
had a significant increase in cash and cash equivalents.
4
Classification of activities on the statement of cash flows
Operating activities: Deliver or produce goods for sale and
provide services. Examples:
Receive cash from customers
Pay cash to suppliers
Pay cash for operating expenses.
Investing activities: Buy or sell long-term assets and other
investments. Examples:
Property, plant, and equipment (PP&E)
Other companies’ securities (that are not cash equivalents)
Financing activities: Obtain or repay capital. Examples:
Borrow from creditors and repay the principal
Issue or repurchase stock
Pay dividends
5

LOS. Compare cash flows from operating, investing, and
financing activities and classify cash flow items as relating to
one of those three categories given a description of the items.
This slide lists the three categories of cash flows: operating,
investing, and financing.
Examples of each category are listed.
5
Colgate: cash flows classified by activity201120102009Net cash
provided by operations2,896 3,211 3,277 Net cash used in
investing activities (1,213) (658) (841)Net cash used in
financing activities (1,242) (2,624) (2,270)Effect of exchange
rate changes(53)(39) (121)Net (decrease) increase in cash and
cash equivalents 388 (110)45 Cash and cash equivalents at
beginning of year 490 600 555 Cash and cash equivalents at
end of year $878 $490 $600
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flow statements.
Colgate consistently obtains its cash inflow from operating
activities.
It uses cash in investing and financing activities.
This profile shows a positive overall cash flow and is fairly
typical for a mature company: Cash generated in operations is
used to make investments for the future and also to repay
capital providers.

In contrast, a start-up company would obtain cash from
financing activities and use the cash to make investments for
the future. A start-up company might not have positive cash
from operations immediately.
We will examine reasons for notable changes.
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Colgate’s operating cash flows
7
LOS. Distinguish between the direct and indirect methods of
flow statements.
This slide shows the operating activities section of Colgate’s
statement of cash flows.
Rather than spend too much time on individual reconciling
items, first focus on the overall relationship between net income
and operating cash flows. Over the long term, for a mature
company, operating cash flows should exceed net income.
If a company has rising net income and falling cash flow, it can
be a red flag.
For example, it might signal potential problems (e.g., slowing
collection of accounts receivable).
However, such a pattern could occur naturally in the early years
of a business.
How does Colgate’s operating cash flow compare with its net

income over the three years? It exceeds it in every year.
Net cash from operations decreased in 2011 compared with
2010. The company’s MD&A (management discussion and
analysis) explains: “Net cash provided by operations in 2011
was $2,896 as compared with $3,211 in 2010 and $3,277 in
2009. The decrease in 2011 as compared to 2010 was primarily
due to an increase in voluntary benefit plan contributions.”
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Colgate’s investing cash flows
8
flow statements.
This slide shows the investing activities section of Colgate’s
The slide also includes the amount of cash provided by
operations.
In every year, Colgate’s cash from operations was more than
enough to cover its capital expenditures.
In 2011, the amounts were cash from operations of $2,896
million and capital expenditures of $537 million.
Investing activities used $1,213 million in 2011, compared with
$658 million and $841 million during 2010 and 2009,
respectively.
In its MD&A, Colgate says the increase was primarily because

of the purchase of the Sanex business for $966 million. Refer to
the item “Payment for acquisitions, net of cash acquired.”
Colgate also discloses that the Sanex acquisition was funded in
part by proceeds from the sale of the Company’s euro-
denominated investment portfolio. Refer to the items “Proceeds
from sale of marketable securities and investments,” which is
greater than “Purchases of marketable securities and
investments” in 2011.
Colgate also discloses that the purchase price was partially
offset by the sale of the Company’s laundry detergent business
in Colombia for $215 million and the receipt of the first
installment of $24 million from the sale of a Mexico City site.
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Colgate’s financing cash flows
9
flow statements.
This slide shows the financing activities section of Colgate’s
Financing activities used $1,242 million of cash during 2011,
much less than the $2,624 million and $2,270 million during
2010 and 2009, respectively.
There are two reasons behind the difference:
First, the company had higher net proceeds from the issuance of

debt. The proceeds from debt issuance in 2011 were $5,843
million compared with principal payments of debt of $4,429
million.
Second, the company had a lower level of share repurchases.
The amount of share repurchases were $1,806 million in 2011
versus $2,020 million in 2010.
The amount of dividends paid has steadily increased over the
past three years.
Referring to amounts from previous slides, it can be noted that
the amounts of operating cash after paying for capital
expenditure, $2,359 million (cash from operations of $2,896
million less capital expenditure of $537 million), was more than
enough to cover the dividend payments of $1,203 million.
9
Common-size statement of cash flow for Colgate
(abbreviated)201120102009Operating ActivitiesNet income
including noncontrolling interests15.3%14.9%15.6% Net cash
provided by operations17.3%20.6%21.4% Net cash used in
investing activities–7.2%–4.2%–5.5% Net cash used in
financing activities–7.4%–16.9%–14.8%
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Each line item is presented as a percentage of net revenue.
flow statements.
In common-size analysis of a company’s income statement, each
income and expense line item is expressed as a percentage of
net revenues (net sales).
For the common-size balance sheet, each asset, liability, and
equity line item is expressed as a percentage of total assets.
For the common-size cash flow statement, there are two

alternative approaches:
Express each line item as a percentage of net revenue.
Express each line item of cash inflow (outflow) as a percentage
of total inflows (outflows) of cash.
This slide shows each category of Colgate’s statement of cash
flow, presented as a percentage of net revenues.
Operating cash flows are consistently close to 20% of net
revenues, although 2011 is somewhat lower.
Investing cash flows as (an absolute) percentage of net revenues
are higher in 2011 than in previous years. As discussed, this
mainly reflects the Sanex acquisition.
Financing cash flows as (an absolute) percentage of net
revenues are lower in 2011 than in previous years. As
discussed, this mainly reflects the net debt proceeds and the
lower amount of share repurchases.
10
Colgate’s cash flows: summary
Overall, $323 million net increase in cash over three years,
from $555 million at the beginning of 2009 to $878 million at
the end of 2011.
Colgate consistently obtains its cash inflow from operating
activities and uses cash in investing and financing activities—a
typical profile for a mature company.
Colgate’s operating cash flow exceeded net income in every
year—a desirable profile for a mature company.
In every year, Colgate’s cash from operations was more than
enough to cover its capital expenditures.
The amount of dividends paid has steadily increased over the
past three years.
Amount of operating cash after paying for capital expenditures
was more than enough to cover the dividend payments.
In summary, Colgate’s cash flows represent a positive profile.

11
flow statements.
11
Colgate’s operating cash flows:
indirect method
12
There are two acceptable formats for reporting cash flow from
operating activities (also known as cash flow from operations or
operating cash flow), defined as the net amount of cash
provided from operating activities: the direct and the indirect
methods.
The amount of operating cash flow is identical under both

methods; only the presentation format of the operating cash
flow section differs.
The presentation format of the cash flows from investing and
financing is exactly the same, regardless of which method is
used to present operating cash flows.
Colgate’s statement is an example of the indirect method of
presenting operating activities. It is indirect because it starts
with net income and then “undoes” accrual accounting and
reclassifies certain amounts to get back to cash provided by
operations.
The net income number—in the indirect method—links to the
income statement.
Rather than spending too much time on individual reconciling
items here, first focus on the overall relationship between net
income and operating cash flows. Over the long term, for a
mature company, operating cash flows should exceed net
income.
If a company has rising net income and falling cash flow, it can
be a red flag.
For example, it might signal potential problems (e.g., slowing
collection of accounts receivable).
However, such a pattern could occur naturally in the early years
of a business.
How does Colgate’s operating cash compare with its net income
over the three years? It exceeds it in every year.
12
Indirect vs. direct method for presenting operating cash flows
Indirect method
Begins with net income and adjusts to operating cash flows.
Arguments for:
Clearly shows the reasons for differences between net income
and operating cash flows.
Mirrors forecasting approach that begins with forecast of

income, then derives cash flows.
Direct method
Shows each cash inflow and outflow related to receipts and
disbursements.
Arguments for:
Provides information on the specific sources of operating cash
receipts and payments.
Does not net.
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The indirect method shows how cash flow from operations can
be obtained from reported net income as the result of a series of
adjustments.
The indirect format begins with net income. To reconcile net
income with operating cash flow, adjustments are made
for noncash items,
for nonoperating items, and
for the net changes in operating accruals.
The main argument for the indirect approach is that it shows the
reasons for differences between net income and operating cash
flows.
Another argument for the indirect method is that it mirrors a
forecasting approach that begins by forecasting future income
and then derives cash flows by adjusting for changes in balance
sheet accounts that occur because of the timing differences
between accrual and cash accounting.
The direct method shows the specific cash inflows and outflows

that result in reported cash flow from operating activities.
The direct method shows each cash inflow and outflow related
to a company’s cash receipts and disbursements. In other words,
the direct method eliminates any impact of accruals and shows
only cash receipts and cash payments.
The primary argument in favor of the direct method is that it
provides information on the specific sources of operating cash
receipts and payments. This is in contrast to the indirect
method, which shows only the net result of these receipts and
payments.
Just as information on the specific sources of revenues and
expenses is more useful than knowing only the net result—net
income—the analyst gets additional information from a direct-
format cash flow statement. The additional information is useful
in understanding historical performance and in predicting future
operating cash flows.
13
Indirect vs. direct method for presenting operating cash flows
Indirect method
IFRS permit.
U.S. GAAP permit.
Used by the majority of companies, whether reporting under
IFRS or U.S. GAAP.
Direct method
IFRS encourage.
U.S. GAAP encourage, but requires a reconciliation of net
income to cash flow from operating activities.
14

LOS. Contrast cash flow statements prepared under
International Financial Reporting Standards (IFRS) and U.S.
generally accepted accounting principles (U.S. GAAP).
IFRS and U.S. GAAP both encourage the use of the direct
method but permit either method.
U.S. GAAP encourage the use of the direct method but also
require companies to present a reconciliation between net
income and cash flow (which is equivalent to the indirect
method).
If the indirect method is chosen, no direct-format disclosures
are required.
The majority of companies, reporting under IFRS or U.S.
GAAP, present using the indirect method for operating cash
flows.
14
Tech data’s operating cash flows:
example of direct method
15
Tech Data’s statement of cash flows is an example of the direct
method of presenting operating activities. It is called “direct”

because it does not start with net income; rather, it just shows
cash collected from clients.
Tech Data is a U.S. GAAP reporting company.
Note that U.S. GAAP require interest paid to be presented in
operating activities, whereas IFRS permit companies to choose
whether to present interest paid in operating or in financing.
The next slide summarizes differences in categorization.
15
Classification of cash flows under IFRS vs. U.S. GAAP
16ItemIFRSU.S. GAAPInterest received
Interest paid
Dividends received
Dividends paidOperating or investing
Operating or financing
Operating or investing
Operating or financingOperating
Operating
Operating
FinancingBank overdraftsConsidered part of cash
equivalentsNot considered part of cash and cash equivalents;
classified as financing.Taxes paidGenerally operating, but a
portion can be allocated to investing or financingOperating
The slide summarizes the key differences for classification of
cash flows between IFRS and U.S. GAAP.
Most significantly, IFRS allow more flexibility in the reporting
of such items as interest paid or received and dividends paid or
received and in how income tax expense is classified.

U.S. GAAP classify interest and dividends received from
investments as operating activities.
IFRS allow companies to classify interest and dividends
received from investments as either operating or investing cash
flows.
U.S. GAAP classify interest expense as an operating activity,
even though the principal amount of the debt issued is classified
as a financing activity.
IFRS allow companies to classify interest expense as either an
operating activity or a financing activity.
U.S. GAAP classify dividends paid to stockholders as a
financing activity.
IFRS allow companies to classify dividends paid as either an
U.S. GAAP classify all income tax expenses as an operating
activity.
IFRS also classify income tax expense as an operating activity,
unless the tax expense can be specifically identified with an
investing or financing activity (e.g., the tax effect of the sale of
a discontinued operation could be classified under investing
activities).
16
Portugal telecom’s operating cash flows: another example of
direct method
17

Portugal Telecom’s statement of cash flows is an example of the
direct method of presenting operating activities. It is called
“direct” because it does not start with net income rather; it just
shows cash collected from clients.
Portugal Telecom’s statement also illustrates the requirement
that cash flow from continuing and discontinued operations be
presented separately.
Portugal Telecom is an IFRS reporting company.
Unlike U.S. GAAP, IFRS do not require the company to report
interest received and paid in the operating section of the
17
Portugal telecom’s investing
cash flows
18
As noted earlier, U.S. GAAP classify interest and dividends
received from investments as operating activities.
IFRS allow companies to classify interest and dividends
received from investments as either operating or investing cash
flows.

This excerpt from Portugal Telecom’s statement of cash flows
illustrates the choice to report interest income and dividends
received in investing activities.
Investing cash flows from continuing and discontinued
operations are presented separately but not shown here to make
the slide more readable.
18
Portugal telecom’s financing
cash flows
19
As noted earlier, U.S. GAAP classify interest expense as an
operating activity, even though the principal amount of the debt
issued is classified as a financing activity. In contrast, IFRS
allow companies to classify interest expense as either an
This excerpt from Portugal Telecom’s statement of cash flows
illustrates the choice to report interest expense in financing
activities.
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noncash investing and
financing activities
Noncash transaction: Any transaction that does not involve an

inflow or outflow of cash (e.g., exchange of one no-monetary
asset for another).
Not incorporated in the cash flow statement.
Must be disclosed.
20
LOS. Describe how noncash investing and financing activities
are reported.
Companies may also engage in noncash investing and financing
transactions.
A noncash transaction is any transaction that does not involve
an inflow or outflow of cash.
For example, if a company exchanges one nonmonetary asset for
another nonmonetary asset, no cash is involved.
Similarly, no cash is involved when a company issues common
stock either for dividends or in connection with conversion of a
convertible bond or convertible preferred stock.
Because no cash is involved in noncash transactions (by
definition), these transactions are not incorporated in the cash
flow statement.
However, because such transactions may affect a company’s
capital or asset structures, any significant noncash transaction is
required to be disclosed, either in a separate note or a
supplementary schedule to the cash flow statement.
20
21
Cash at beginning and end of year links to the balance sheet.

accounting period.
Starting at the bottom of the statement of cash flows, we see the
increase and decrease in cash and cash equivalents each year.
Increase (decrease) in cash (in millions)
2011 388
2010 (110)
2009 45
Overall, $323 million net increase in cash over three years from
$555 million at the beginning of 2009 to $878 million at the end
of 2011.
In general, what are the implications of too little cash? Too
much?
The amount of cash at the beginning and the end of the year
links to the balance sheet. See next slide.
21
22
Cash at beginning and end of year links to the balance sheet.

This slide shows the bottom few lines of Colgate’s statement of
cash flows and the top line of Colgate’s balance sheet.
The amount of cash at the beginning and the end of the year
links to the balance sheet.
The amount of $490 million was Colgate’s cash balance at the
end of 2010, which of course is also its cash balance at the
beginning of 2011.
22
Preparation of the Statement of
Cash Flows: Steps
Step 1. Determine the change in cash.
Step 2. Determine the net cash flow from operating activities.
Use both the current year's income statement and information on
current assets and liabilities from the comparative balance
sheets.
Step 3. Determine net cash flows from investing and financing
activities. Examine all other changes in the balance sheet
accounts.
Step 4. Include summary of net increase (decrease) in cash, cash
at beginning, and cash at end.
Step 5. Disclose any significant noncash transactions separately
at the bottom of the statement.
23
LOS. Describe the steps in the preparation of direct and indirect
cash flow statements, including how cash flows can be
computed using income statement and balance sheet data.
Slide lists steps in preparing statement of cash flows.

23
Example
A new company has the following transactions:
Sells stock for $100.
Buys a building for $50. Its primary line of business is selling a
service, so it has no COGS (cost of goods sold) and no
inventory.
Makes credit sales of $100, and subsequently collects $90.
Accrues SG&A (selling, general, and administrative) expense of
$40, and subsequently pays cash of $25.
Records depreciation expense of $10.
24
The accompanying Excel spreadsheet posts the transactions
listed on this slide into a tabular summary from which an ending
balance sheet can be created.
24
Step 1. Determine the change in cashBeginning balanceEnding
balanceChangeCash0115 115 Accounts receivable010 10
Building050 50 Accumulated depreciation0(10)(10)Total
assets0165165 Accounts payable015 15 Common stock0100 100
Retained earnings050 50 Total liabilities and equity0165 165
This step is straightforward. The information is on the
comparative balance sheets. Change was $115.

25
This is a new company, so beginning balances are all $0.
The company sells stock for $100, increasing cash by $100 and
common stock by $100.
It buys a building for $50. Its primary line of business is selling
a service, so it has no COGS and no inventory. It decreased
cash by $50 and increased building assets by $50.
It makes credit sales of $100 and subsequently collects $90. It
increased cash by $90, accounts receivable by $10, and retained
earnings by $100.
It accrues an SG&A expense of $40 and subsequently pays cash
of $25. It decreased cash by $25, decreased retained earnings by
$40, and increased accounts payable by $15.
It records a depreciation expense of $10. It decreased retained
earnings by $10 and increased accumulated depreciation (contra
asset) by $10.
25
Step 2. Determine the net cash flow from operating activities,
beginning with Net Income for the indirect methodIncome
statementCredit sales$ 100SG&A expense–40Depreciation
expense–10Net income$ 50Net income$ 50+ Depreciation
expense+10Noncash expense– Change in receivables–10Only
collected $90 + Change in payables+15Only paid $25Cash from
operating activities$ 65

26
Net income is reduced by depreciation expense, but notice that
this expense is completely (and always) noncash.
Thus, to convert from accrual income to cash-based income, we
have to undo the effects of all noncash items, such as
depreciation.
Change in receivables and payables from beginning and ending
balance sheets.
Formula for calculating Operating Cash Flow:
Net income + Depreciation – Changes in assets + Changes in
liabilities
= Operating cash flows
Note: Other refinements may be necessary to eliminate
nonoperating items if, for example, the company reported a gain
on sale of investment.
26
activitiesBeginning balanceEnding balanceChangeCash0115 115
In first stepAccounts receivable010 10 In operatingBuilding050
50 ?Accumulated depreciation0(10)(10)In operatingTotal
assets0165165 Accounts payable015 15 In operatingCommon
stock0100 100 ?Retained earnings050 50 In operating*Total
liabilities0165 165
Examine all other changes in the balance sheet accounts.
*There are no dividends in this example; all changes in retained
earnings are from net income

27
We are checking off each balance sheet item as we go.
We have dealt with all the checked items in the first two steps.
27
Investing cash flows
Determine investing cash flows by examining changes in long-
term assets. In this example, we have only PP&E.
Beginning PP&E + Purchases – Dispositions = Ending PP&E
Ending PP&E – Beginning PP&E = Purchases – Dispositions
(i.e., investing cash flows)
PP&E increased by $50, indicating cash spent acquiring PP&E.
We also know this from the transaction list at the beginning of
the example.
28
PP&E went up by $50, so assume that $50 cash was spent
acquiring PP&E, which we know explicitly from the description
of the firm’s activities at the beginning of the example.

Note that we are looking at gross PP&E, not net.
28
Financing cash flows
Determine financing cash flows by examining changes in debt
and equity accounts. In this example, we have only common
stock.
Beginning stock + Issuances – Repurchases = Ending stock
Ending stock – Beginning stock = Issuances – Repurchases
Stock account increased by $100, indicating cash was raised by
issuing stock.
We also know this from the transaction list at the beginning of
the example.
29
PP&E went up by $50, so assume that $50 cash was spent
acquiring PP&E, which we know explicitly from the description
of the firm’s activities at the beginning of the example.
Because the stock account rose by $100, we assume that $100 of
cash was received, which again, we know explicitly.
29
activitiesBeginning balanceEnding balanceChangeCash0115 115
In first stepAccounts receivable010 10 In operatingBuilding050
50 In investingAccumulated depreciation0(10)(10)In

operatingTotal assets0165165 Accounts payable015 15 In
operatingCommon stock0100 100 In financingRetained
earnings050 50 In operating*Total liabilities0165 165
Examine all other changes in the balance sheet accounts.
*There are no dividends in this example, so all change was net
income.
30
We are checking off each balance sheet item as we go.
All the items have been dealt with.
30
Company ABCCash Flow Statement for the period
ended Operating cash flowNet income50Depreciation expense+
10Increase in accounts receivable– 10Increase in accrued
liabilities+ 15Total operating cash flow+ 65Investing cash
flowCapital expenditure– 50Financing cash flowIssue of stock+
100Total change in cash+ 115Beginning cash balance0Ending
cash balance115
Indirect method
31

Having completed all the steps, this slide presents the statement
of cash flows.
This statement shows Step 4 (including the summary of net
increase [decrease] in cash, cash at beginning, and cash at end).
In this example, Step 5 (disclose any significant noncash
transactions separately, at the bottom of the statement) is not
relevant because there were no significant noncash transactions.
31
Alternative Step 2. Determine the net cash flow from operating
activities, beginning with each line item for the direct
methodIncome statementCredit sales$ 100SG&A expense–
40Depreciation expense–10Net income$ 50Cash from
customers$ 90Credit sales ($100) minus Change in receivables
($10)Cash paid for expenses–25SG&A expenses ($40) minus
increase in payables ($15)Cash from operating activities$ 65
32
LOS. Convert cash flows from the indirect to direct method.
Create the operating cash flows with the direct method; work
through each line item of the income statement.
There are credit sales of $100, but based on the increase in
receivables of $10, one can tell that the company only collected
$90 in cash.
There was an SG&A expense of $40, but based on the increase
in payables of $15, one can tell that the company only paid cash
of $25.

The depreciation expense is noncash, so it should not be
included.
If working from a statement of cash flows prepared with the
indirect method, it is necessary to remove all nonoperating
items from revenue (e.g., gain on sale of equipment) and to
remove all noncash expenses from expenses.
32
Company ABCCash Flow Statement for the period ended Cash
collected from customers+ 90Cash paid to suppliers– 25Total
operating cash flow+ 65Investing cash flowCapital expenditure–
50Financing cash flowIssue of stock+ 100Total change in cash+
115Beginning cash balance0Ending cash balance115
direct method
33
LOS. Convert cash flows from the indirect to direct method.
Cash from customers = Sales ($100) – Change in receivables
($10) = $90
Cash to suppliers = SG&A expense ($40) – Change in payables
($15) = $25
If working from a statement of cash flows prepared with the
indirect method, it is necessary to remove all nonoperating
items from revenue (e.g., gain on sale of equipment) and to
remove all noncash expenses from expenses.
33

Free Cash Flow
Free Cash Flow to the Firm (FCFF): Cash flow available to the
company’s suppliers of capital (debt and equity).
After all operating expenses (including taxes) have been paid.
After all operating investments have been made for fixed capital
and working capital.
Free Cash Flow to Equity (FCFE): Cash flow available to the
company’s common stockholders.
After all operating expenses (including taxes) have been paid.
After borrowing costs (principal and interest) have been paid.
After all operating investments have been made for fixed capital
and working capital.
34
LOS. Calculate and interpret free cash flow to the firm, free
cash flow to equity, and performance and coverage cash flow
ratios.
It was mentioned earlier that it is desirable that operating cash
flows are sufficient to cover capital expenditures (also known as
fixed capital expenditures).
The excess of operating cash flow over capital expenditures is
known generically as free cash flow.
For purposes of valuing a company or its equity securities, an
analyst may want to determine and use other cash flow
measures, such as free cash flow to the firm (FCFF) or free cash
flow to equity (FCFE).
FCFF is the cash flow available to the company’s suppliers of
debt and equity capital after all operating expenses (including
income taxes) have been paid and necessary investments in
working capital and fixed capital have been made.
CFO represents cash flow from operating activities under U.S.

GAAP or under IFRS where the company has included interest
paid in operating activities.
Under IFRS, if interest paid was included in financing
activities, then CFO does not have to be adjusted for Int(1 – Tax
rate).
Under IFRS, if the company has placed interest and dividends
received in investing activities, these should be added back to
CFO to determine FCFF. In addition, if dividends paid were
subtracted in the operating section, these should be added back
in to compute FCFF.
34
Compute FCFF
Net Income
+ Noncash charges
– Working capital investment
+ Interest expense × (1 – Tax rate)
– Fixed capital investments
= FCFF
Interest, a cash flow available to one of the capital providers,
which has been deducted from net income, so it must be added
back
35
ratios.
FCFF is the cash flow available to the company’s suppliers of
debt and equity capital after all operating expenses (including

income taxes) have been paid and necessary investments in
working capital and fixed capital have been made.
FCFF can be computed starting with net income as
FCFF = NI + NCC + Int(1–Tax rate) – FCInv – WCInv
where
NI = Net income
NCC = Noncash charges (such as depreciation and
amortization)
Int = Interest expense
FCInv = Capital expenditures (fixed capital, such as
equipment)
WCInv = Working capital expenditures
The reason for adding back interest is that FCFF is the cash
flow available to the suppliers of debt capital as well as equity
capital.
35
FCFF can also be computed from cash flow from operating
activities
Net income
+ Noncash charges
= Cash from operating activities
+ Interest Expense × (1 – Tax rate)
– Fixed capital investments
= FCFF
CFO already has added noncash items to net income and
deducted working capital investment
36

ratios.
Conveniently, FCFF can also be computed from cash flow from
operating activities as
FCFF = CFO + Int(1–Tax rate) – FCInv
36
Compute FCFE
Net Income
+ Noncash charges
– Fixed capital investment
+ Net new borrowing (or minus net debt repayments)
= FCFE
37
Positive FCFE means that the company has an excess of
operating cash flow over amounts needed for capital
expenditures and repayment of debt.
ratios.

FCFE: Free cash flow after investment in working capital and
fixed capital, available to equityholders only.
Net new borrowing excludes interest payments to debtholders,
excludes principal repayments to debtholders, and includes any
increases in borrowing.
Positive FCFE means that the company has an excess of
operating cash flow over amounts needed for capital
expenditures and repayment of debt. This cash would be
available for distribution to owners.
37
Cash flow performance ratiosRatioCalculationWhat It
MeasuresCash flow to revenueCFO ÷ Net revenueOperating
cash generated per dollar of revenueCash return on assetsCFO ÷
Average total assetsOperating cash generated per dollar of asset
investmentCash return on equityCFO ÷ Average shareholders’
equityOperating cash generated per dollar of owner
investmentCash to incomeCFO ÷ Operating incomeCash
generating ability of operations Cash flow per share(CFO –
Preferred dividends) ÷ Number of common shares outstanding
Operating cash flow on a per-share basis
38
ratios.
If the company reports under IFRS and includes total dividends
paid as a use of cash in the operating section, total dividends
should be added back to CFO as reported, and then preferred
dividends should be subtracted. Recall that CFO reported under

U.S. GAAP and IFRS may differ depending on the treatment of
interest and dividends, received and paid.
Ratios based on cash flows provide information that help an
analyst better understand the company’s past performance
(trend and cross-sectional) and develop expectations about the
company’s future prospects.
This slide list several performance ratios based on operating
cash flow. In general, these ratios measure the cash return
relative to alternative financial items.
38
Cash flow coverage ratiosRatioCalculationWhat It
MeasuresDebt coverageCFO ÷ Total debtFinancial risk and
financial leverageInterest coverage(CFO + Interest paid + Taxes
paid) ÷ Interest paidAbility to meet interest
obligationsReinvestmentCFO ÷ Cash paid for long-term assets
Ability to acquire assets with operating cash flowsDebt
paymentCFO ÷ Cash paid for long-term debt repaymentAbility
to pay debts with operating cash flowsDividend paymentCFO ÷
Dividends paidAbility to pay dividends with operating cash
flowsInvesting and financingCFO ÷ Cash outflows for investing
and financing activitiesAbility to acquire assets, pay debts, and
make distributions to owners
39
ratios.
Ratios based on cash flows provide information that help an
analyst better understand the company’s past performance
(trend and cross-sectional) and develop expectations about the
company’s future prospects.

This slide list several coverage ratios based on operating cash
flow. In general, these ratios measure the extent to which
operating cash flow “covered” various of the company’s
expenditures and commitments.
39
Summary
accounting period.
Cash flows are categorized as operating, investing, and
financing.
Compared with U.S. GAAP, IFRS provide companies with more
choices in classifying some cash flow items as operating,
investing, or financing activities.
The operating activities section of the statement of cash flows
can be presented using the direct method or the indirect method.
Two approaches to developing common-size cash flow
statements are the total cash inflows/total cash outflows method
and the percentage of net revenues method.
Cash flow ratios measure a company’s profitability,
performance, and financial strength.
40
40

Chapter 5
Understanding Balance Sheets
Presenter’s name
Presenter’s title
dd Month yyyy
Customization notes:
Hyperlinks to the annual reports of companies used in this
presentation are provided at the bottom of certain pages. If the
presenter saves the annual report to the same computer drive on
which the PowerPoint presentation is saved, clicking the
hyperlink will take the presenter to the annual report. Note also
that the relevant items are bookmarked in each annual report
PDF. To navigate to the bookmarked pages, select the bookmark
icon once the PDF is open (2nd down on far left of screen when
PDF is opened).
LEARNING OUTCOMES
Describe the elements of the balance sheet: assets, liabilities,
and equity.
Describe uses and limitations of the balance sheet in financial
analysis.
Describe alternative formats of balance sheet presentation.
Distinguish between current and noncurrent assets, and current
and noncurrent liabilities.
Describe different types of assets and liabilities and the

measurement bases of each.
Describe the components of shareholders’ equity.
Convert balance sheets to common-size balance sheets and
interpret the common-size balance sheets.
Calculate and interpret liquidity and solvency ratios.
1
Overview
Balance sheet elements and format
Accounting issues
Current and noncurrent assets and liabilities
Measurement bases of different assets and liabilities
Components of shareholders’ equity
Balance sheet analysis
Liquidity and solvency
2
2
balance sheet contents
The balance sheet is also known as the statement of financial
position or statement of financial condition.
The balance sheet discloses, at a specific point in time,
what an entity owns (or controls),
what it owes, and
what the owners’ claims are.
Assets = Liabilities + Owners’ equity
3

LOS. Describe the elements of the balance sheet: assets,
liabilities, and equity.
The balance sheet is also called the statement of financial
position or statement of financial condition.
IFRS uses the term “statement of financial position” (IAS 1,
Presentation of Financial Statements), although U.S. GAAP uses
the two terms interchangeably (ASC 210-10-05 [Balance Sheet–
Overall–Overview and Background]).
The balance sheet discloses what an entity owns (or controls),
what it owes, and what the owners’ claims are at a specific
point in time.
The equation A = L + E is sometimes summarized as follows:
The left side of the equation reflects the resources controlled by
the company, and the right side reflects how those resources
were financed.
3
balance sheet elements
Assets (A): resources controlled by the company as a result of
past events and from which future economic benefits are
expected to flow to the entity.
Liabilities (L): obligations of a company arising from past
events, the settlement of which is expected to result in an
outflow of economic benefits from the entity.
Equity (E): represents the owners’ residual interest in the
company’s assets after deducting its liabilities.
4

The financial position of a company is described in terms of its
basic elements (assets, liabilities, and equity):
Assets (A) are what the company owns (or controls). More
formally, assets are resources controlled by the company as a
result of past events and from which future economic benefits
are expected to flow to the entity.
Liabilities (L) are what the company owes. More formally,
liabilities represent obligations of a company arising from past
events, the settlement of which is expected to result in an
outflow of economic benefits from the entity.
Equity (E) represents the owners’ residual interest in the
company’s assets after deducting its liabilities. Commonly
known as shareholders’ equity or owners’ equity, equity is
determined by subtracting the liabilities from the assets of a
company.
Equations: A – L = E and A = L + E
Depending on the sophistication of the audience, the presenter
could use the concept that a company’s equity is analogous to
an individual’s net worth: total assets minus total liabilities.
For all financial statement items, an item should only be
recognized in the financial statements if it is probable that any
future economic benefit associated with the item will flow to or
from the entity and if the item has a cost or value that can be
measured with reliability.
4
equity
The balance sheet provides important information about a
company’s financial condition.
However, balance sheet amounts of equity (assets, net of
liabilities) should not be viewed as a measure of either the

market or intrinsic value of a company’s equity.
Why?
The balance sheet is a mixed model with respect to
measurement (some items at historical cost, some items at
current value).
Even current value reflects a value that was current at the end
of the reporting period.
Future cash flows, which affect value, are driven by items
excluded from the balance sheet (e.g., reputation, management
skills).
5
LOS. Describe uses and limitations of the balance sheet in
financial analysis.
The balance sheet provides important information about a
company’s financial condition, but the balance sheet amounts of
equity (assets, net of liabilities) should not be viewed as a
measure of either the market or intrinsic value of a company’s
equity for several reasons.
First, the balance sheet under current accounting standards is a
mixed model with respect to measurement. Some assets and
liabilities are measured based on historical cost, sometimes with
adjustments, whereas other assets and liabilities are measured
based on a current value. The measurement bases may have a
significant effect on the amount reported.
Second, even the items measured at current value reflect the
value that was current at the end of the reporting period. The
values of those items obviously can change after the balance
sheet is prepared.
Third, the value of a company is a function of many factors,
including future cash flows expected to be generated by the
company and current market conditions. Important aspects of a

company’s ability to generate future cash flows—for example,
its reputation and management skills—are not included in its
balance sheet.
5
Balance sheet: example
Colgate-Palmolive company (assets)
6
Colgate's Annual Report
This slide shows the assets portion of the balance sheet of
Colgate-Palmolive.
The assets are typical for a manufacturer: cash; receivables;
inventories; property, plant, and equipment; goodwill; and
intangibles.
We will examine the main types of assets in later slides.
Asset composition of firms varies depending on industry.
6
Colgate-Palmolive company (liabilities)
7

This slide shows the liabilities portion of the balance sheet of
Colgate-Palmolive.
The types of liabilities are typical for most companies: accounts
payable, notes payable, long-term debt (payable), and accrued
income taxes (payable).
7
Colgate-Palmolive company (equity)
8
This slide shows the equity portion of the balance sheet of
Colgate-Palmolive.
Total equity ($2,541) equals total assets ($12,724) minus total
liabilities ($10,183).
We will examine the main components of equity in later slides.
8
Balance sheet format
Liquidity
For a company overall, its ability to pay for short-term
obligations

For a particular asset or liability, its “nearness to cash”
Balance sheet ordering according to liquidity
Companies using U.S. GAAP (e.g., Colgate) order items on the
balance sheet from most liquid to least liquid.
Companies using IFRS order balance sheet information from
least liquid to most liquid.
9
LOS. Describe alternative formats of balance sheet presentation.
LOS. Distinguish between current and noncurrent assets, and
current and noncurrent liabilities.
A company’s ability to pay for its short-term operating needs
relates to the concept of liquidity.
With respect to a company overall, liquidity refers to the
availability of cash to meet those short-term needs.
With respect to a particular asset or liability, liquidity refers to
its “nearness to cash.”
A liquid asset is one that can be easily converted into cash in a
short period of time at a price close to fair market value.
For example, a small holding of an actively traded stock is
much more liquid than an asset like a commercial real estate
property in a weak property market.
Ordering according to liquidity:
In general, financial statements prepared in accordance with
IFRS present balance sheet information in the reverse order of
liquidity compared with U.S. GAAP. For example, using IFRS,
assets are presented starting with noncurrent assets followed by
current assets, and equity is presented first, followed by
noncurrent liabilities and current liabilities.
IFRS does not prescribe the reverse ordering. IAS 1,
Presentation of Financial Statements, Paragraph 57: “This

Standard does not prescribe the order or format in which an
entity presents items.”
9
Henkel AG (assets)
10
Henkel's Annual Report
This slide shows the asset portion of the balance sheet of
Henkel AG & Co., a German company that prepares its financial
statements under IFRS. Henkel has laundry and home care,
cosmetics/toiletries, and adhesive technologies businesses. The
company has numerous well-known brands, including Persil,
Purex, and Dial.
Henkel’s balance sheet illustrates the following differences
from Colgate’s balance sheet:
It illustrates the ordering of assets from least liquid to most
liquid, with noncurrent intangible assets at the top and cash at
the bottom.
It uses the title “consolidated statement of financial position”
rather than balance sheet.
It presents the older year 2010 to the left of the more recent
year 2011.
It supplies the number of the relevant footnote on the face of
the balance sheet.
It presents additional columns showing each line item of assets
as a percentage of total assets.

10
L’ORÉAL (assets)
11
L’Oréal's Annual Report
L’Oréal SA, a French cosmetics company that prepares its
financial statements under IFRS.
L’Oréal’s balance sheet illustrates the following differences
from Colgate’s and Henkel’s balance sheets:
Like Henkel and different from Colgate, L’Oréal’s balance
sheet orders assets from least liquid to most liquid, with
noncurrent intangible assets at the top and cash at the bottom.
Like Colgate and different from Henkel, it uses the title
“balance sheet” rather than “consolidated statement of financial
position.”
Like Colgate and different from Henkel, it presents the most
recent year in the left-most column.
Like Colgate and different from Henkel, it presents the older
year 2010 to the left of the more recent year 2011.
Like Henkel and different from Colgate, it supplies the number
of the relevant footnote on the face of the balance sheet.
L’Oréal’s balance sheet also illustrates the requirement under
IFRS for a third balance sheet (and related notes) as of the
beginning of the earliest comparative period presented when an
entity restates its financial statements.

11
current and noncurrent
assets and liabilities
Balance sheet must distinguish between and present separately
current and noncurrent assets
current and noncurrent liabilities
Exception to the current and noncurrent classifications
requirement, under IFRS:
Current and noncurrent classifications are not required if a
liquidity-based presentation provides reliable and more relevant
information.
In a liquidity-based presentation, all assets and liabilities
presented in order of liquidity.
Liquidity-based presentation are often used by banks.
Classified balance sheet: Balance sheet with separately
classified current and noncurrent assets and liabilities.
12
The definition of current/noncurrent is provided later.
The separate presentation of current and noncurrent assets and
liabilities enables an analyst to examine a company’s liquidity
position (at least as of the end of the fiscal period).
Both IFRS and U.S. GAAP require that the balance sheet
distinguish between current and noncurrent assets and between
current and noncurrent liabilities and present these as separate
classifications.

A balance sheet with separately classified current and
noncurrent assets and liabilities is referred to as a classified
balance sheet.
An exception to this requirement, under IFRS, is that the
current and noncurrent classifications are not required if a
information.
IAS 1, paragraph 60: “An entity shall present current and non-
current assets, and current and non-current liabilities, as
separate classifications in its statement of financial position in
accordance with paragraphs 66–76 except when a presentation
based on liquidity provides information that is reliable and more
relevant. When that exception applies, an entity shall present all
assets and liabilities in order of liquidity.”
All three of the companies featured in the previous examples
show a subtotal for current assets and current liabilities.
12
Barclays plc (assets)
13
Barclays' Annual Report
Both IFRS and U.S. GAAP require that the balance sheet
distinguish between current and noncurrent assets and between
current and noncurrent liabilities and present these as separate
classifications.
An exception to this requirement, under IFRS, is that the

current and noncurrent classifications are not required if a
information.
IAS 1, paragraph 60: “An entity shall present current and non-
current assets, and current and non-current liabilities, as
separate classifications in its statement of financial position in
accordance with paragraphs 66–76 except when a presentation
based on liquidity provides information that is reliable and more
relevant. When that exception applies, an entity shall present all
assets and liabilities in order of liquidity.”
All three of the companies featured in the previous examples
show a subtotal for current assets and current liabilities.
Barclays PLC (Barclays), a U.K.-headquartered global financial
services provider engaged in retail banking, credit cards,
wholesale banking, investment banking, wealth management,
and investment management services.
Barclays reports under IFRS.
The balance sheet illustrates a liquidity-based presentation.
13
current and noncurrent
assets and liabilities
Current assets: Assets expected to be sold, used up, or
otherwise realized in cash within one year or one operating
cycle of the business, whichever is greater, after the reporting
period.
Noncurrent assets: Assets not classified as current. Also known
as long-term or long-lived assets.
Current liabilities: Liabilities expected to be settled within one
year or within one operating cycle of the business.
Noncurrent liabilities: All liabilities not classified as current.
Working capital: The excess of current assets over current
liabilities.
14

Assets held primarily for the purpose of trading or expected to
be sold, used up, or otherwise realized in cash within one year
or one operating cycle of the business, whichever is greater,
after the reporting period are classified as current assets.
A company’s operating cycle is the average amount of time that
elapses between acquiring inventory and collecting the cash
from sales to customers. For a manufacturer, this is the average
amount of time between acquiring raw materials and converting
these into cash from a sale.
Examples of companies that might be expected to have
operating cycles longer than one year include those operating in
the tobacco, distillery, and lumber industries. Even though these
types of companies often hold inventories longer than one year,
the inventory is classified as a current asset because it is
expected to be sold within an operating cycle.
Assets not expected to be sold or used up within one year or one
operating cycle of the business, whichever is greater, are
classified as noncurrent (or long-term or long-lived) assets.
Current assets are generally maintained for operating purposes,
and these assets include, in addition to cash, items expected to
be
converted into cash (e.g., trade receivables),
used up (e.g., office supplies, prepaid expenses), or
sold (e.g., inventories) in the current period.
Current assets provide information about the operating activities
and the operating capability of the entity. For example, the item
“trade receivables” or “accounts receivable” would indicate that
a company provides credit to its customers.
Noncurrent assets represent the infrastructure from which the
entity operates and are not consumed or sold in the current

period. Investments in such assets are made from a strategic and
longer-term perspective.
Similarly, liabilities expected to be settled within one year or
within one operating cycle of the business, whichever is greater,
after the reporting period are classified as current liabilities.
The specific criteria for classification of a liability as current
include the following:
It is expected to be settled in the entity’s normal operating
cycle.
It is held primarily for the purpose of being traded.
It is due to be settled within one year after the balance sheet
date.
The entity does not have an unconditional right to defer
settlement of the liability for at least one year after the balance
sheet date.
IFRS specify that some current liabilities, such as trade
payables and some accruals for employee and other operating
costs, are part of the working capital used in the entity’s normal
operating cycle. Such operating items are classified as current
liabilities even if they will be settled more than one year after
the balance sheet date.
When the entity’s normal operating cycle is not clearly
identifiable, its duration is assumed to be one year.
All other liabilities are classified as noncurrent liabilities.
Noncurrent liabilities include financial liabilities that provide
financing on a long-term basis.
The excess of current assets over current liabilities is called
“working capital.” The level of working capital tells analysts
something about the ability of an entity to meet liabilities as
they fall due. Although adequate working capital is essential,
working capital should not be too large because funds may be
tied up that could be used more productively elsewhere.
14
Measurement bases of current assets:
cash and cash equivalents

Cash Equivalents: Highly liquid, short-term investments that are
so close to maturity that the risk of significant change in value
from changes in interest rates is minimal.
Examples:
demand deposits with banks
highly liquid investments with original maturities of three
months or less (e.g., U.S. T- bills, commercial paper, money
market funds)
For cash and cash equivalents, amortized cost and fair value are
likely to be immaterially different.
15
LOS. Describe different types of assets and liabilities and the
Accounting standards require that certain specific line items, if
they are material, must be shown on a balance sheet. Among the
current assets’ required line items are cash and cash
equivalents, trade and other receivables, inventories, and
financial assets (with short maturities). Companies present other
line items as needed, consistent with the requirements to
separately present each material class of similar items.
Cash and Cash Equivalents. Cash and cash equivalents are
financial assets. Financial assets, in general, are measured and
reported at either amortized cost or fair value. Amortized cost is
the historical cost (initially recognized cost) of the asset
adjusted for amortization and impairment.
Under IFRS, fair value is the amount at which an asset could be
exchanged or a liability settled in an arm’s length transaction
between knowledgeable and willing parties.
Under U.S. GAAP, the definition is similar but it is based on an
exit price, the price received to sell an asset or paid to transfer
a liability, rather than an entry price.

For cash and cash equivalents, amortized cost and fair value are
likely to be immaterially different.
Examples of cash equivalents are demand deposits with banks
and highly liquid investments (such as U.S. Treasury bills,
commercial paper, and money market funds) with original
maturities of three months or less. Cash and cash equivalents
excludes amounts that are restricted in use for at least 12
months. For all companies, the statement of cash flows presents
information about the changes in cash over a period.
15
Measurement bases of cash and cash equivalents: example
disclosures
“Cash Equivalents. Highly liquid investments with remaining
stated maturities of three months or less when purchased are
considered cash equivalents and recorded at cost.”
Procter & Gamble (2011), annual report
“Cash and cash equivalents. Cash and cash equivalents consist
of cash in bank accounts, units of cash unit trusts and liquid
short-term investments with a negligible risk of changes in
value and a maturity date of less than three months at the date
of acquisition. . . . Units of cash unit trusts are considered to be
assets available for sale. As such, they are valued in the balance
sheet at their market value at the closing date. Any related
unrealized gains are accounted for in Finance costs, net in the
income statement. The carrying amount of bank deposits is a
reasonable approximation of their fair value.”
L’Oréal (2011), annual report
16

This slide presents example disclosures regarding cash and cash
equivalents.
The Procter & Gamble disclosure states that the company
records cash equivalents at cost.
The L’Oréal disclosure illustrates the measurement of cash
equivalents at market value.
1.20. Cash and cash equivalents
Cash and cash equivalents consist of cash in bank accounts,
units of cash unit trusts and liquid short-term investments with
a negligible risk of changes in value and a maturity date of less
than three months at the date of acquisition. Investments in
shares and cash, which are held in an account blocked for more
than three months, cannot be recorded under cash and are
presented under Other current assets. Bank overdrafts are
considered to be financing and are presented in Current
borrowings and debt. Units of cash unit trusts are considered to
be assets available for sale. As such, they are valued in the
balance sheet at their market value at the closing date. Any
related unrealized gains are accounted for in Finance costs, net
in the income statement. The carrying amount of bank deposits
is a reasonable approximation of their fair value.
16
trade receivables
Trade receivables: Amounts owed to a company by its
customers for products and services already delivered.
Also referred to as accounts receivable.
Typically reported at net realizable value, an approximation of
fair value, based on estimates of collectability.
Aspects of accounts receivable often relevant to an analyst:

overall level of accounts receivable relative to sales,
allowance for doubtful accounts, and
concentration of credit risk.
17
Trade receivables, or accounts receivable, are another type of
financial asset.
These are amounts owed to a company by its customers for
products and services already delivered.
They are typically reported at net realizable value, an
approximation of fair value, based on estimates of
collectability.
Several aspects of accounts receivable are usually relevant to an
analyst.
First, the overall level of accounts receivable relative to sales (a
topic to be addressed further in ratio analysis) is important
because a significant increase in accounts receivable relative to
sales could signal that the company is having problems
collecting cash from its customers.
Second, the allowance for doubtful accounts reflects the
company’s estimate of amounts that will ultimately be
uncollectible.
Additions to the allowance in a particular period are reflected as
bad debt expenses, and the balance of the allowance for
doubtful accounts reduces the gross receivables amount to a net
amount that is an estimate of fair value.
When specific receivables are deemed to be uncollectible, they
are written off by reducing accounts receivable and the

allowance for doubtful accounts.
The allowance for doubtful accounts is called a contra asset
account because it is netted against (i.e., reduces) the balance of
accounts receivable, which is an asset account.
The age of an accounts receivable balance refers to the length of
time the receivable has been outstanding, including how many
days past the due date.
Another relevant aspect of accounts receivable is the
concentration of credit risk. For example, a company’s credit
risk is more limited when it has a large number of customers
diversified across various industries and countries versus only
one or a few customers accounting for a large percent of either
revenue or receivables.
17
Measurement bases of receivables:
L’ORÉAL Example
Based on the note below, what percentage of its receivables did
L’Oréal estimate will be uncollectible?
18
Answer:
For 2011, €46.2 divided by €3,042.3 = 1.52%.
For 2010, €48.1 divided by €2,733.4 = 1.76%.
For 2009, €50.2 divided by €2,493.5 = 2.01%.
This example illustrates valuation of accounts receivable net of
allowance for doubtful accounts (i.e., estimated uncollectible
amounts).

This example also illustrates analysis relating the amount of
allowance to the amount of gross receivables.
The amount of allowance for doubtful accounts is related to bad
debt expense and thus to reported net income.
Bad debt expense is an expense of the period, based on a
company’s estimate of the percentage of credit sales in the
period, for which cash will ultimately not be collected. The
allowance for bad debts is a contra asset account, which is
netted against the asset accounts receivable.
To record the estimated bad debts, a company recognizes a bad
debt expense (which affects net income) and increases the
balance in the allowance for doubtful accounts by the same
amount.
To record the write-off of a particular account receivable, a
company reduces the balance in the allowance for doubtful
accounts and reduces the balance in accounts receivable by the
same amount.
L’Oréal’s allowance decreased as a percentage of gross
receivables over the past three years.
In general, some factors that could cause a company’s
allowance for doubtful accounts to decrease as a percentage of
accounts receivable include the following:
Improvements in the credit quality of the company’s existing
customers (whether driven by a customer-specific improvement
or by an improvement in the overall economy);
Stricter credit policies (for example, refusing to allow less
creditworthy customers to make credit purchases and instead
requiring them to pay cash, to provide collateral, or to provide
some additional form of financial backing); and/or
Stricter risk management policies (for example, buying more
insurance against potential defaults).
In addition to these business factors, because the allowance is
based on management’s estimates of collectability, management
can potentially bias these estimates to manipulate reported
earnings.
L’Oréal’s note further discloses that its “Group policy is to

recommend credit insurance coverage as far as local conditions
allow. The non-collection risk on trade receivables is therefore
minimized, and this is reflected in the level of the allowance,
which is less than 2% of gross receivables.”
Elsewhere in the annual report, L’Oréal’s discussion of risk
notes that “due to the large number and variety of distribution
channels at worldwide level, the likelihood of occurrence of
significant damage on the scale of the Group remains limited.
The 10 largest customers/distributors represent around 18% of
the Group’s sales.”
18
Measurement basis of current assets: Inventory
Goods
Purchased
Beginning
Inventory
Goods
Available
for
Sale
Ending
Inventory
Cost of
Goods Sold
Balance Sheet
Income Statement
Inventory Cost Flow
19

This slide illustrates the cost flow of inventory for a company
that purchases inventory items for resale (e.g., a wholesaler or
retailer).
It illustrates that the measurement basis of inventory on the
balance sheet is directly related to measurement of cost of
goods sold on the income statement.
During the period, the company purchases goods, which are
added to its beginning inventory. Beginning inventory plus
purchases equals goods available for sale.
As the goods are sold and revenues are recognized, the cost of
goods sold will be removed from inventory and recorded as an
expense.
Any items not sold during the period remain in ending
inventory.
19
inventory
U.S. GAAP
Lower of cost or market (LCM):
Market defined as replacement cost with a floor (Net realizable
value, or NRV, less normal profit margin) and a ceiling (NRV).
NRV defined as estimated selling price less estimated costs of
completion and sale.
Reversals of prior write-downs are NOT allowed.
Permits last in, first out (LIFO).
IFRS
Lower of cost or net realizable value (LCNRV):
NRV defined as estimated selling price less estimated costs of
completion and sale.

Reversals of prior write-downs can be made and recognized in
income.
Does not permit LIFO.
20
Inventory measurement is one area where differences between
U.S. GAAP and IFRS are notable.
Inventories are measured at the lower of cost and net realizable
value under IFRS and at the lower of cost or market under U.S.
GAAP.
The cost of inventories comprises all costs of purchase, costs of
conversion, and other costs incurred in bringing the inventories
to their present location and condition.
Net realizable value (NRV), the measure used by IFRS, is the
estimated selling price less the estimated costs of completion
and costs necessary to make the sale.
Under U.S. GAAP, market value is defined as current
replacement cost but with upper and lower limits: It cannot
exceed NRV and cannot be lower than NRV less a normal profit
margin.
If the net realizable value (under IFRS) or market value (under
U.S. GAAP) of a company’s inventory falls below its carrying
amount, the company must write down the value of the

inventory.
The loss in value is reflected in the income statement.
Under IFRS, if inventory that was written down in a previous
period subsequently increases in value, the amount of the
original write-down is reversed. Subsequent reversal of an
inventory write-down is not permitted under U.S. GAAP.
When inventory is sold, the cost of that inventory is reported as
an expense, “cost of goods sold.”
Accounting standards allow different valuation methods for
determining the amounts that are included in cost of goods sold
on the income statement and thus the amounts that are reported
in inventory on the balance sheet.
Inventory valuation methods are referred to as cost formulas
and cost flow assumptions under IFRS and U.S. GAAP,
respectively.
IFRS allows only the first-in, first-out (FIFO), weighted
average cost, and specific identification methods.
Some accounting standards (such as U.S. GAAP) also allow the
last-in, first-out (LIFO) method as an additional inventory
valuation method. The LIFO method is not allowed under IFRS.
20
Measurement bases of noncurrent assets:
Property, plant, and equipment
Property, plant, and equipment (PP&E): Tangible assets that are
used in company operations over more than one fiscal period.
Under the cost model, PP&E is reported at historical cost less
any accumulated depreciation and less any impairment losses.
Depreciation: Systematic allocation of cost over an asset’s
useful life.
Land is not depreciated.
Impairment losses reflect an unanticipated decline in value.
Reversals of impairment losses are permitted under IFRS but
not under U.S. GAAP.
Under the revaluation model, PP&E is reported at fair value at

the date of revaluation less any subsequent accumulated
depreciation.
The revaluation model is NOT permitted under U.S. GAAP.
21
Property, plant, and equipment (PP&E) are tangible assets that
are used in company operations and expected to be used
(provide economic benefits) over more than one fiscal period.
Examples of tangible assets treated as property, plant, and
equipment include land, buildings, equipment, machinery,
furniture, and natural resources, such as mineral and petroleum
resources.
IFRS permit companies to report PP&E using either a cost
model or a revaluation model. Although IFRS permit companies
to use the cost model for some classes of assets and the
revaluation model for others, the company must apply the same
model to all assets within a particular class of assets.
U.S. GAAP permit only the cost model for reporting PP&E.
Under the cost model, PP&E is carried at amortized cost
(historical cost less any accumulated depreciation or
accumulated depletion and less any impairment losses).
Historical cost generally consists of an asset’s purchase price,
its delivery cost, and any other additional costs incurred to
make the asset operable (such as costs to install a machine).
Depreciation, and depletion, is the process of allocating
(recognizing as an expense) the cost of a long-lived asset over
its useful life.
Land is not depreciated.

Because PP&E is presented on the balance sheet net of
depreciation and depreciation expense is recognized in the
income statement, the choice of depreciation method and the
related estimates of useful life and salvage value affect both a
company’s balance sheet and income statement.
Whereas depreciation is the systematic allocation of cost over
an asset’s useful life, impairment losses reflect an unanticipated
decline in value.
Impairment occurs when the asset’s recoverable amount is less
than its carrying amount, with terms defined as follows under
IFRS:
Recoverable amount: The higher of an asset’s fair value less
cost to sell and its value in use.
Fair value less cost to sell: The amount obtainable in a sale of
the asset in an arm’s-length transaction between knowledgeable
willing parties less the costs of the sale.
Value in use: The present value of the future cash flows
expected to be derived from the asset.
When an asset is considered impaired, the company recognizes
the impairment loss in the income statement.
Reversals of impairment losses are permitted under IFRS but
not under U.S. GAAP.
Under the revaluation model, the reported and carrying value
for PP&E is the fair value at the date of revaluation less any
subsequent accumulated depreciation. Changes in the value of
PP&E under the revaluation model affect equity directly or
profit and loss depending upon the circumstances.
21
Measurement bases of noncurrent assets:
Property, plant, and equipment
U.S. GAAP
Permit only the cost model for reporting PP&E.

Reversals of prior impairment losses are NOT allowed.
IFRS
Permit either cost model or revaluation model.
Can use different models for different classes of assets.
Must apply same model to all assets within a particular class.
Reversals of impairment losses are permitted.
22
PP&E measurement is another area where differences between
U.S. GAAP and IFRS are notable.
This slide summarizes key differences.
22
Measurement bases of Property, plant, and equipment: example
disclosure
“During 2008, Portugal Telecom changed the accounting policy
regarding the measurement of real estate properties and the

ducts infra-structure from the cost model to the revaluation
model. . . . [Revaluation amounts totaled] Euro 1,075,033,022
that was recognized in the Consolidated Statement of
Comprehensive Income. . . .
Portugal Telecom performed another revaluation of the real
estate assets and ducts infrastructure in the year ended 31
December 2011. . . [resulting] in a net reduction of tangible
assets amounting to Euro 131,418,994, of which Euro
126,167,561 was recognized directly in the Consolidated
Statement of Comprehensive Income (Note 44.5) under the
caption ‘Revaluation reserve’ and Euro 5,251,433 was
recognized in the Consolidated Income Statement under the
caption ‘Depreciation and amortization.’”
23
Portugal Telecom (2011), Form 20-F, note 37.4
This excerpt of the disclosure from Portugal Telecom, SGPS,
S.A.’s FORM 20-F, for the fiscal year ended 31 December 2011,
illustrates use of the revaluation model under IFRS. A more
complete excerpt is provided below.
Per the disclosure shown:
The original revaluation of the classes of PP&E in 2008 created
a revaluation reserve of more than €1 billion (a revaluation
reserve is a component of shareholders’ equity).
In the current year (2011), the revaluation resulted in a net
reduction of €131 million, of which
€126 million was recognized as comprehensive income and
€5 million was recognized on the income statement as part of

depreciation and amortization.
3 Significant accounting policies, judgments and estimates
c) Tangible assets
In 2008, Portugal Telecom changed the accounting policy
regarding the measurement of real estate properties and ducts
infra-structure from the cost model to the revaluation model,
since it believes the latter better reflects the economic value of
those asset classes, given the nature of the assets revalued,
which are not subject to technological obsolescence. The
increase in tangible assets resulting from the revaluation
reserves, which are non-distributable reserves, is being
amortized in accordance with the criteria used to amortize the
revalued assets. Portugal Telecom has adopted the policy to
revise the revalued amount every 3 years.
The remaining tangible assets are stated at acquisition cost, net
of accumulated depreciation, investment subsidies and
accumulated impairment losses, if any. . . .
37.4. Revaluations
During 2008, Portugal Telecom changed the accounting policy
regarding the measurement of real estate properties and the
ducts infra-structure from the cost model to the revaluation
model (Note 3). The revaluations of the real estate properties
and ducts infra-structure were effective as at 30 June 2008 and
30 September 2008, and resulted in a revaluation of the assets
by Euro 208,268,320 and 866,764,702, respectively, totaling an
amount of Euro 1,075,033,022 that was recognized in the
Consolidated Statement of Comprehensive Income.
In accordance with the Group’s accounting policy to revalue
these assets at least every three years, Portugal Telecom
performed another revaluation of the real estate assets and ducts
infrastructure in the year ended 31 December 2011, through the
same methodology described above. These revaluations were
effective as at 31 December 2011 and resulted in a net reduction

of tangible assets amounting to Euro 131,418,994, of which
Euro 126,167,561 was recognized directly in the Consolidated
Statement of Comprehensive Income (Note 44.5) under the
caption ‘Revaluation reserve’ and Euro 5,251,433 was
recognized in the Consolidated Income Statement under the
caption “Depreciation and amortization.”
23
Measurement bases of noncurrent assets: intangible assets
Intangible assets: Identifiable nonmonetary assets without
physical substance (e.g., patents, licenses, trademarks).
Goodwill, which arises in business combinations and is not a
separately identifiable asset, is covered separately in IFRS.
Measurement models for intangible assets:
IFRS allow either a cost model or a revaluation model for
intangible assets.
U.S. GAAP allow only the cost model.
Measurement of intangible assets subsequent to acquisition:
Intangible asset with finite useful life: Amortize over useful life
and assess for impairment when indicated.
Intangible asset with indefinite useful life: Do not amortize, but
assess for impairment (annually under IFRS; only after
qualitative assessment under U.S. GAAP).
24
Intangible assets - For example:
Patent: Exclusive right to a product or process, granted by the
government to an inventor for a limited time.
License: Exclusive right to perform some activity, typically

granted by a government to the purchaser of a license for a
limited time.
Trademark: Exclusive right to word, name, symbol, or device
that distinguish goods and services from those manufactured or
sold by others. Can be renewed forever as long as it is being
used in commerce.
Goodwill: Not a separately identifiable asset. Arises when a
company acquires another company for a price in excess of fair
market value of net identifiable assets acquired.
IFRS allow companies to report intangible assets using either a
cost model or a revaluation model.
The revaluation model can only be selected when there is an
active market for an intangible asset so that fair value can be
determined by reference to an active market.
Such active markets are expected to be uncommon for
intangible assets. Examples where they might exist are for some
types of licenses (fishing licenses, taxi licenses).
U.S. GAAP permit only the cost model.
For each intangible asset, a company assesses whether the
useful life of the asset is finite or indefinite.
Indefinite life: No foreseeable limit to the period over which the
asset is expected to generate net cash inflows for the entity.
Finite life: A limited period of benefit to the entity.
Amortization and impairment principles apply as follows:
An intangible asset with a finite useful life
Is amortized on a systematic basis over the best estimate of its
useful life, with the amortization method and useful life
estimate reviewed at least annually.
Impairment principles for an intangible asset with a finite
useful life are the same as for PPE.
An intangible asset with an indefinite useful life
Is not amortized.
Instead, at least annually, the reasonableness of assuming an
indefinite useful life for the asset is reviewed and the asset is
tested for impairment.
Note that under U.S. GAAP, ASU 2012-02 changed the

requirements for a quantitative assessment of impairment for
indefinite-lived intangible assets.
Previous guidance required a company to test for impairment on
at least an annual basis by comparing the asset’s carrying value
with its estimated fair value.
The new Accounting Standards Update issued in July 2012
provides that a company can first “assess qualitative factors to
determine whether it is more likely than not [defined as > 50%]
that an indefinite-lived intangible asset is impaired as a basis
for determining whether it is necessary to perform the
quantitative impairment test.” This new guidance is similar to
that for goodwill impairment testing in ASU 2011-08 issued in
September 2011. In other words, if a company determines
qualitatively that impairment is not more than 50%, it does not
have to undertake quantitative tests (i.e., it has the option to
forego an annual calculation of the fair value of an indefinite-
lived intangible asset).
If an intangible asset is deemed to be impaired, an impairment
loss is charged against income in the current period.
An impairment loss reduces current earnings.
An impairment loss also reduces total assets, so some
performance measures, such as return on assets (net income
divided by average total assets), may actually increase in future
periods.
An impairment loss is a noncash item.
24
Measurement bases of noncurrent assets: goodwill
Goodwill
Arises when a company acquires another company for a price in
excess of fair market value of net identifiable assets acquired.
Is equal to purchase price of business minus fair market value
of net assets acquired.
Represents value of all favorable attributes that relate to a
business enterprise.

Is recorded only when there is an exchange transaction that
involves the purchase of an entire business.
Is not amortized, but must be assessed for impairment.
Accounting goodwill does not equal economic goodwill.
25
When one company acquires another, if the purchase price is
greater than the acquirer’s interest in the fair value of the
identifiable assets and liabilities acquired, the excess is
described as goodwill and is recognized as an asset. Why might
an acquirer pay more to purchase a company than the fair value
of the target company’s identifiable assets net of liabilities?
First, as noted, certain items not recognized in a company’s own
financial statements (e.g., its reputation, established distribution
system, trained employees) have value.
Second, a target company’s expenditures in research and
development may not have resulted in a separately identifiable
asset that meets the criteria for recognition but nonetheless may
have created some value.
Third, part of the value of an acquisition may arise from
strategic positioning versus a competitor or from perceived
synergies. For example, the acquisition might have been aimed
at protecting the value of all of the acquirer’s own existing
assets.
Accounting goodwill is not the same as economic goodwill.
Accounting goodwill is based on accounting standards and is
reported only in the case of acquisitions.
Economic goodwill is based on the economic performance of the
entity, and it is not necessarily reflected on the balance sheet.

Instead, economic goodwill is reflected in the stock price (at
least in theory).
Some financial statement users believe that goodwill should not
be listed on the balance sheet because it cannot be sold
separately from the entity. Other financial statement users
analyze goodwill and any subsequent impairment charges to
assess management’s performance on prior acquisitions.
Under both IFRS and U.S. GAAP, accounting goodwill arising
from acquisitions is capitalized.
Goodwill is not amortized but is tested for impairment.
Requirements are similar to those for indefinite-lived,
separately identifiable intangible assets described on the
previous slide.
If goodwill is deemed to be impaired, an impairment loss is
charged against income in the current period.
An impairment loss reduces current earnings.
An impairment loss also reduces total assets, so some
performance measures, such as return on assets (net income
divided by average total assets), may actually increase in future
periods.
An impairment loss is a noncash item.
25
Measurement bases of financial assets
26
Here, financial assets refers to a company’s investments in
stocks issued by another company or its investments in the
notes, bonds, or other fixed-income instruments issued by

another company (or issued by a governmental entity). This
discussion pertains to investments where ownership does not
give the investor control (which would require consolidation) or
significant influence (which would require equity method
accounting).
In general, there are two basic alternative ways that financial
instruments are measured:
Fair value: the price that would be received to sell an asset or
paid to transfer a liability.
Amortized cost: the amount at which an asset was initially
recognized, minus any principal repayments, plus or minus any
amortization of discount or premium, and minus any reduction
for impairment.
Financial assets are measured at amortized cost if
the asset’s cash flows occur on specified dates and consist
solely of principal and interest, and
the business model is to hold the asset to maturity. This
category of asset is referred to as held-to-maturity.
Examples include
An investment in a long-term bond issued by another company;
for example, the value of the bond will fluctuate with interest
rate movements, but if the bond is classified as held-to-
maturity, it will be measured at amortized cost.
A loan to another company.
Financial assets not measured at amortized cost are measured at
fair value. How are any unrealized net changes in fair value
recognized? Two alternatives are
as profit or loss on the income statement, or
as other comprehensive income (loss), which bypasses the
income statement.
Note that these alternatives refer to unrealized changes in fair
value (i.e., changes in the value of a financial asset that has not
been sold and is still owned at the end of the period).
Unrealized gains and losses are also referred to as holding
period gains and losses. If a financial asset is sold within the
period, a gain is realized if the selling price is greater than the

carrying value and a loss is realized if the selling price is less
than the carrying value. When a financial asset is sold, any
realized gain or loss is reported on the income statement.
The category of held for trading (or “trading securities” under
U.S. GAAP) refers to a category of financial assets that is
acquired primarily for the purpose of selling in the near term.
Such assets are
likely to be held only for a short period of time.
measured at fair value, and any unrealized holding gains or
losses are recognized as profit or loss on the income statement.
The category of financial assets measured at fair value, with any
unrealized holding gains or losses recognized in other
comprehensive income, are
referred to as available-for-sale assets under U.S. GAAP. They
are not trading assets, but they are available to be sold.
referred to as “financial assets measured at fair value through
other comprehensive income” under IFRS. At the time a
company buys an equity investment that is not held for trading,
the company is permitted to make an irrevocable election to
measure the asset in this manner.
The relevant section is Paragraph 5.7.5 of IFRS 9, Financial
Instruments: “At initial recognition, an entity may make an
irrevocable election to present in other comprehensive income
subsequent changes in the fair value of an investment in an
equity instrument within the scope of this IFRS that is not held
for trading.”
26
Financial Assets
Measured at Fair Value
Changes in Value through Profit and Loss
Trading Securities (stocks and bonds)

Changes in Value through OCI
IFRS: Designated Equity Investments
U.S. GAAP: Available-for-Sale Debt or Equity
Measured at Amortized Cost:
- Held-to-Maturity
- Debt Instruments
Common types of Current liabilities
Trade payables, also known as accounts payable: Amounts that
a company owes its vendors for purchases of goods and
services—in other words, the unpaid amounts of the company’s
purchases on credit as of the balance sheet date.
Notes payable: Financial liabilities owed by a company to
creditors, including trade creditors and banks, through a formal
loan agreement.

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