Question

1) To add....A balance sheet provides information about a "company's financial flexibility, liquidity and solvency" As accounting students , You know that solvency pertains to the ability of a company to pay its debts as they come due. Liquidity on the other hand pertains to the amount of time it takes for an asset to be converted into cash.

FOR YOU AND THE CLASS: What is the meaning of financial flexibility and how important is it to a company?

2) some of the limitations of the balance sheet are that " some assets that cannot be expressed in monetary terms such as skills, loyalty of workers, or the company's reputation cannot be reflected. To add, the reasons why the values of these items are not recorded in the balance sheet concern the lack of faithful representation of the estimates of the future cash flows that will be generated by these assets.

FOR YOU AND THE CLASS: How can the skills, loyalty of workers ,customer base and reputation of the company be reliably measured or how will you approach measuring these items.... please explain

3) one of the limitations of the balance sheet is that "Companies use "judgements and estimates" to determine many items in the Balance Sheet'. This is true since judgments and estimates affect the amounts reported in the balance sheet as there is subjectivity in determining the amounts

FOR YOU AND THE CLASS: What are some situations and examples in which estimates affect amounts reported in the balance sheet....Please discuss

Answer 1

The answer explains the details about

1.What is the meaning of financial flexibility and how important is it to a company

2.How can the skills, loyalty of workers ,customer base and reputation of the company be reliably measured

3.estimates affect amounts reported in the balance sheet.

1. F                                             In order to examine the importance of financial flexibility hypothesis in financial decisions, we focus on firms decisions on cash holdings and debt/equity financing which are the main sources of financial flexibility (DeAngelo and DeAngelo (2006)). Firms lacking in financial flexibility would increase cash holdings while reducing leverage ratios. Even though we consider the dividend policy in relation to financial flexibility, we do not take it as a source of financial flexibility but rather as the decision following from having ample flexibility. Thus, the dividend policy is taken as an identifier of a firm s flexibility. We also consider firm size, retained earnings and long-term credit ratings as interrelated measures of the firm s financial flexibility. Small growing firms typically have high demand for financial flexibility and have accumulated less profits than large firms, causing them to concern for financial flexibility. For example, small firms with accumulated losses (measured by retained earnings) are likely to have little financial flexibility and debt capacity but ample need for additional cash. Our main hypothesis is that small firms with negative retained earnings are more likely to issue equity to build up cash holdings and preserve debt capacity for financial flexibility and hence will have low leverage. A corollary to this hypothesis is that cash holdings will be negatively associated with leverage. We find supporting evidence for these predictions. On the other hand, large mature firms with ample retained earnings are almost selffinancing and have low leverage. Thus, their large cash flows are subject to opportunity/agency costs of free cash flow (Jensen and Meckling (1976)). Increasing debt financing may address the free cash flow problem but it may reduce financial flexibility to cope with future uncertainties. Thus, they prefer paying dividends in order to preserve debt capacity while reducing free cash flow. This implies that large firms with ample retained earnings also have lower leverage. The important implication of the financial flexibility hypothesis is that there is a negative relationship between firm size and leverage ratio, conditional on negative retained earnings, whereas there a positive relationship between firm size and leverage ratio, conditional on positive retained earnings.
 For example, a firm may invest in safe and liquid investments rather than in risk ones (Almeida et. al. (2006)) or alter the dividend policy, when facing financial constraints and running out of other financial resources. However, firms are less likely to alter their investment and dividend policies when they have other sources of financial flexibility such as cash holdings and debt capacity. Accordingly, for the purpose of investigating the effect of financial flexibility on the capital structure decision, we assume that firms make financing decisions in order to accommodate future investment opportunities. Similarly, we consider a firm s dividend policy not as in itself the immediate source of financial flexibility but as a policy to reflect the firm s financial flexibility condition. In order to understand how a financial flexibility concern affects a firm s financial decisions, suppose a firm with a constant optimal debt ratio (debt/assets) of 0.5 currently has $200 financial surplus with uncertain financing needs in the next few years. In order to preserve financial flexibility for the unforeseeable future financing needs, the firm should make financial decisions today. Considering costs and benefits, suppose the firm set the optimal financing plan of raising $300 by next period (shown as negative numbers at t = 1) as follows: t = 0 1 Surplus = $200 = $400 Assets = $1000 -$300 The firm s current debt ratio is 0.4. The static target adjustment model predicts that the firm will use the current financial surplus to repurchase equity and then issue $150 debt and $150 equity in the next period in order to maintain the optimal debt ratio of 0.5. However, if the transaction costs of repurchasing and reissuing equity are greater than those of debt, the firm will reduce debt rather than equity with the surplus cash and preserve the debt capacity (as financial flexibility) for the future financing need despite the belowinancial flexibility is related to a firm's overall financial structure and if its financial policies allow it flexibility to take advantage of unforseen opportunities. A flexible f short- term financial policy would maintain a high level of current assets relate to sales,such as maintaining large cash balance, maintaining large inventory level, offereing liberal credit terms, leading to more sales and a higher receivable book.

target debt ratio.2. The non- monetary attributes like skill, loyalty of workers , customer base and reputation of the firm. But these are not involved in the financial aspects or financial reports of the firm. But all the firm give a great importance to these items in the present business world.
   In today’s commercial business environment, being able to run an effective, growing and profitable business requires not only dedicated and satisfied customers but also new quality customers that will become the repeat customers of tomorrow. It is unlikely that a customer would enter into business transactions with a company that does not provide value in some fashion. Likewise, no company can survive, grow and have the value of future revenue streams from a cadre of satisfied customers without providing superior value on a continual and consistent basis. Together this mutual transfer of value creates a symbiotic relationship between customer and business. Equally as important as satisfied, repeat customers is having happy, motivated employees. Companies must retain existing high quality employees while building and fostering a culture that attracts new and highly talented employees as the business grows. As the outward face of a business and as the single largest piece of intellectual capital a business ‘owns’, employee loyalty to the business and the principles for which it strives are often under estimated. Their judgments, experiences, and capabilities make the difference between success and failure (Bossidy/Charan, p.109, 2002). This enthusiasm is what creates, builds and reinforces the internal cultures of an organization; the culture that ultimately becomes one of the greatest attractors to both new employees and customers. Yet these ideas of loyalty, culture, human capital and knowledge in the forms of experienced customers, employees and investors are some of the most difficult tangible assets of a business to measure (Reichheld, 1996, p 4). In fact they are so difficult to measure that modern day accounting standards do not list 2 them as assets on the financial records of a company. However, few seem to question that effective management of a company requires the understanding of these forces in order to stay competitive. Focused measurement and the ability to harness and to effectively use the collected information of these basic, but fundamental, items has recently been the focus of many modern management theories such as ‘Building a Loyalty Business’, ‘The Balanced Scorecard’, and several other popular studies and discussions. All of these methods seem to have in common one focus area: customer and employee loyalty and retention. Focusing on either customer or employee acquisition and retention can provide for excellent growth. These two effects coupled together have the potential to lead to gains that neither one by itself could deliver alone (Reichheld, 1996, p 52). Past Department of Defense Secretary (SECDEF) William Perry was insistent that the Department had to become more commercial like in its business practices. He and others under his direction initiated some of the most wide reaching business process restructurings in the Department’s history. The current SECDEF Donald Rumsfeld has also been widely quoted on his continual support of the adoption of both best business practices as well as capturing the entrepreneurial sprit in the Department’s ongoing business methods. As we prepare for the future, we must think differently and develop the kinds of forces and capabilities that can adapt quickly to new challenges and to unexpected circumstances. We must transform not only the capabilities at our disposal, but also the way we think, the way we train, the way we exercise and the way we fight. We must transform not only our armed forces, but also the Department that serves them by encouraging a culture of creativity and prudent risk-taking. We must promote an entrepreneurial approach to developing military capabilities, one that encourages people to be proactive, not reactive, and anticipates threats before they emerge.
3. Accounting estimates are approximate values assigned by a company’s management to different accounting variables. Whenever a company changes such estimates, it is required to reflect the change only in current and future periods, but not in past periods.
Accounting elements are either definite, such as invoice price of a fixed asset, cost of freight, cost of insurance, an employee’s base salary, a building’s rent, interest expense on a fixed-rate loan, etc., or variable, such as useful life of a fixed asset, potential doubtful debts expense, potential warranty expense, potential damages payable under a law suit, etc. Accounting information is reliable when it is definite, but in many cases definite information become available only with the passage of time. In many situations, a company is required to strike a balance between relevance and reliability. The management is required to apply its best judgment to particular circumstances to arrive at an expected value.
Under IFRS, IAS 8 provides guidance on how to make accounting estimates and how to account for any change in such estimates over a period. It requires companies to reflect changes in estimates prospectively.
Examples
Examples of changes in estimate include:
•       Change in useful life and salvage value of a fixed asset or intangible asset
•       Change in provision for bad debts
•       Change in provision for obsolescence of inventories
•       Change in defined benefit obligation
Example: Prospective Application
CAE, Inc. is an airline that owns an XYZ aircraft that it bought in 2006 for $300 million. At the time of recognition of the aircraft as a fixed asset, i.e. on 1 January 2006, the company estimated its useful life to be 15 years and expected it to fetch $50 million at the end of its useful life.
The company uses straight-line depreciation method for the aircraft.
Regulatory changes introduced in November 2013 barred the company from flying this aircraft after the end of 2015. The company cannot fly it on any alternate route either. The management is forced to sell it and acquire an upgrade aircraft by end of 2015. It revised the useful life of the aircraft down to 10 years and increased its salvage value to $90 million.
Illustrate how the company will account for the developments in financial year ending 31 December 2014.
Solution
From 2006 to 2013, the company must have recorded yearly depreciation expense of $16.67 million [= ($300 million - $50 million) ÷ 15].
By end of 2013, the aircraft served 8 years of its 15-year useful life. Its book value at the end of 2013 comes out to be $166.6 [= $300 million - $16.67 million × 8].
The regulatory changes forced the company to reduce useful life down to 10 years. It means the remaining useful life as at 1 January 2014 was 2 years.
Depreciation expense for 2014 = ($166.6 million – $90 million) ÷ 2 = $38.32 million
Please note that the change in estimate is reflected only in periods subsequent to the change. It doesn’t affect any of the historical depreciation expense or book values.