An entity presents a summary of its assets, liabilities,
and owners’ equity in its balance sheet. The results of its operations are presented
in the income statement. Many financial statement users are also interested in the
origin of the funds of an enterprise (sources of funds), and the uses the enterprise
makes of these funds (applications of funds). This flow of funds information is
contained in the statement of changes in financial position.
APB Opinion 19 requires the inclusion of the statement
of changes in financial position whenever a balance sheet and income statement are
presented by a profit-oriented business. This statement must include all changes
in the funds of an enterprise and any important changes in its financial position.
All important aspects of financing and investing must be included. However, it is
not necessary to include transactions affecting only stockholder equity accounts
such as stock splits and stock dividends.
Funds may be defined by management as working capital,
cash, or cash and marketable securities. Working capital, which is equal to current
assets less current liabilities, is the most frequently used concept.
Sources of Funds
An increase in working capital is a source of funds. The
various kinds of sources of funds are presented below.
Funds provided from operations:
This category basically represents net income. Funds are
derived from sales since cash and accounts receivable are increased. Funds are used
for expenses and the purchase of goods. Hence, the excess of sales over costs and
expenses represents the increase in working capital.
The computation of funds provided from operations is somewhat
more complex than that explanation indicates. Net income must be adjusted for nonworking
capital components. We must add back to net income nonworking capital expenses that
were deducted in determining profit but that did not result in a decrease in working
capital. For example, depreciation expense reduces earnings but does not reduce
working capital. Other expenses added back to net income are depletion expense,
amortization expense, and loss on the sale of fixed assets. We must subtract from
net income nonworking capital revenues that were added in determining profit but
did not result in an increase in working capital. Common examples include the amortization
of deferred income and the gain on the sale of fixed assets.
Working capital provided from operations is the first
source of funds listed in the statement of changes in financial position.
Decrease in noncurrent assets. When noncurrent assets
(e.g., fixed assets, long-term investments) are sold, working capital is increased.
Increase in noncurrent liabilities: The issuance of long-term
(e.g., bonds payable, mortgage payable, long-term notes
payable) results in an increase in working capital.
Increase in stockholders’ equity. The issuance of equity
securities (common stock and preferred stock) results in an increase in working
capital. However, transactions involving only stockholder equity accounts (intra-stockholder
equity transactions) are not shown since they do not affect working capital. Examples
are stock dividends and appropriation of retained earnings.
Working capital is not affected by a transaction that
affects only current asset or current liability accounts. Therefore, this type of
transaction is not reported in the statement of changes in financial position. Examples
are the collection of an account receivable or the payment of an account payable.
Applications of Funds
A decrease in working capital is an application of funds.
Various uses of funds are presented below:
Increase in noncurrent assets: The acquisition of
property, plant” equipment, and long-term investments involves a reduction in working
capital. The purchase usually requires the payment of cash or the incurrence of
a current liability.
Decrease in noncurrent liabilities. The payment of long-term
debt (e.g., bonds payable, long-term notes payable) involves a use of working capital.
Decrease in stockholders’ equity. The reduction in stockholders’
equity represents a use of funds. An example is the declaration of a cash dividend
that results in the current liability Cash Dividends Payable. Other applications
are the purchase of treasury stock and the redemption of preferred stock since they
involve the payment of cash.
Material Noncurrent Transactions
APB Opinion 19 requires that the all financial resources
concept be used in preparing the statement of changes in financial position. The
all financial resources concept requires that the following be reported:
1. Transactions affecting working capital must be reported.
2. Transactions not affecting working capital must be
reported if they are of a material noncurrent nature. These transactions are shown
at the bottom of the statement to comply with the disclosure principle.
A material noncurrent transaction is reported as if it
involved two separate transactions: a source of funds and an application of funds.
Examples are the acquisition of equipment (application) for the incurrence of long-term
debt (source) and the conversion of bonds payable (application) to common stock
Schedule of Changes in Working Capital Accounts
The initial step in preparing a statement of changes in
financial position is to determine the net increase or decrease in working capital
for the period. This is shown in a schedule of changes in working capital accounts.
Working capital increases if a current asset increases or a current liability decreases.
Working capital decreases if a current asset decreases or a current liability increases.
Statement of Changes in Financial Position
The statement of changes in financial position provides
concise information about how a company generated and used its working capital during
the period. An analysis of the statement is useful in appraising past performance,
forecasting future trends in working capital, and evaluating the firm’s ability
to satisfy its debts at maturity.
The purpose of the statement of changes in financial position
is to explain why working capital increased or decreased. This is accomplished by
listing the specific sources and applications of working capital during the period.
The statement is prepared through an analysis of the changes which occurred during
the year in the noncurrent accounts.