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 non-current assets. When non-current assets (e.g., fixed assets, long-term investments) are sold, working capital is increased.
Increase in non-current liabilities: The issuance of long-term obligations
(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 (extra-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
Increase in non-current 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 in-current of a current liability.
Decrease in non-current 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 Non-current 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:
- Transactions affecting working capital must be reported.
- Transactions not affecting working capital must be reported if they are of a material non-current nature. These transactions are shown at the bottom of the statement to comply with the disclosure principle.
A material non-current 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 in-current of long-term debt (source) and the conversion of bonds payable (application) to common stock (source).
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 non-current accounts.