Chapter 3 Financial Statements, Cash Flows, and Taxes Learning Objectives 1. Discuss generally accepted accounting principles (GAAP) and their importance to the economy. 2. Know the balance sheet identity, and explain why a balance sheet must balance. 3. Describe how market-value balance sheets differ from book- value balance sheets. 4. Identify the basic equation for the income statement and the information it provides. 5. Explain the difference between cash flows and accounting income. Page 1 of 91
Transcript
Chapter 3
Financial Statements, Cash Flows, and Taxes
Learning Objectives
1. Discuss generally accepted accounting principles (GAAP) and their importance to the
economy.
2. Know the balance sheet identity, and explain why a balance sheet must balance.
3. Describe how market-value balance sheets differ from book-value balance sheets.
4. Identify the basic equation for the income statement and the information it provides.
5. Explain the difference between cash flows and accounting income.
6. Explain how the four major financial statements discussed in this chapter are related.
7. Discuss the difference between average and marginal tax rates.
I. Chapter Outline
3.1 Financial Statements and Accounting Principles
A. Annual Reports
The annual report is a vehicle by which management communicates with the
firm’s shareholders and members of the public.
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The annual report has three sections—a financial summary related to the past
year’s performance; information about the company, its products, and its
activities; and audited financial statements, including historical financial data.
B. Generally Accepted Accounting Principles (GAAP)
These are accounting rules and standards that companies need to adhere to
when they prepare financial statements and reports.
GAAP is prepared by the Financial Accounting Standards Board (FASB) and
is authorized by the SEC.
C. Fundamental Accounting Principles
The Assumption of Arm’s-Length Transaction—Two parties involved in an
economic transaction arrive at a decision independently and rationally.
The Cost Principle—Transactions are recorded at the cost at which they
occurred.
The Realization Principle—Revenue is recognized when transaction is
completed, while cash may not be collected until a later time.
The Matching Principle—Expenses related to generating any revenue are
matched.
The Going Concern Assumption—It is assumed that a company will continue
to operate for the predictable future.
D. International GAAP
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The International Accounting Standards Board promotes uniform accounting
rules and procedures.
All European Union firms are expected to comply with International
Accounting Standards (IAS), since 2007.
The SEC does not recognize IAS and requires foreign firms listed on U.S.
stock exchanges to use U.S. GAAP.
3.2 The Balance Sheet
A. This financial statement identifies all the assets and liabilities of a firm at a point
in time.
The left-hand side of the balance shows all the assets that the firm owns and
uses to generate revenues.
The right-hand side represents the liabilities of the firm—that is, the money
that the firm has borrowed from both creditors and shareholders.
In addition to the amount borrowed from suppliers and other creditors, the
balance sheet also lists the capital raised from its shareholders.
While assets are listed in their order of their liquidity, the liabilities are listed
in the order in which they must be paid.
Shareholders of the firm’s common equity are listed last as they will be paid
with whatever remains after paying all other suppliers of funds.
B. Current Assets and Liabilities
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All assets that are likely to be converted to cash within a year are considered
to be current assets. These include cash and marketable securities, accounts
receivables, and inventory.
All liabilities that have to be paid within a year are listed as part of the current
liabilities. Thus, bank loans and other borrowings with less than a year’s
maturity, accounts payables, accrued wages, and taxes are included here.
The difference between the amount of current assets and current liabilities is
called net working capital.
C. Net Working Capital
Net working capital is a measure of the liquidity of a firm, which is the ability
of the firm to meet its obligations as they come due.
As expressed in Equation 3.2, net working capital is the difference between
total current assets and total current liabilities.
D. Accounting for Inventory
Inventory, the least liquid of current assets, is reported in one of two different
ways on the balance sheet.
First in, first out, or FIFO, refers to the practice of recognizing a sale as being
made up of inventory that was purchased earlier and having the lowest cost.
Last in, last out, or LIFO, calls for the firm to attribute any sale made to the
most recently acquired and most expensive inventory.
FIFO reporting leads to higher current asset value and higher net income.
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Firms may switch from one to another only under extraordinary circumstances
and not frequently.
E. Long-Term Assets
These are the real assets that the firm acquires to produce its products and
generate cash flows. These include land, buildings, plant, and equipment.
Intangible assets, such as goodwill, patents, and copyrights, are also listed
here.
All long-term real assets are depreciated, while intangible assets are
amortized. Depreciating assets allows a firm to lower taxable income and
reduce taxes.
Firms are allowed to depreciate assets using the straight-line method or an
accelerated depreciation method that is allowed by the IRS.
F. Long-Term Liabilities
These consist of the long-term debt of the company.
They include bank loans, mortgages, and bonds that have a maturity of one
year or longer.
G. Equity
There are two sources of equity funds—common equity and preferred equity.
Common equity represents the true ownership of the firm.
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Multiple accounts identify the various sources of equity funds—par value,
additional paid-in capital, retained earnings, and treasury stock.
Par value and paid-in capital represent the outside equity capital raised by the
firm by issuing shares.
Retained earnings result from the funds that the firm has reinvested in the firm
from its earnings. These funds are not cash since they already have been put to
work.
The treasury stock account reflects the value of the shares that the firm
repurchased from investors.
The other source of equity capital is preferred stock. It has features that make
it a combination of a fixed income security and an equity security.
3.3 Market Value versus Book Value
Traditionally, all assets are reported at their historical cost.
The balance sheet does not reflect the current market value of the assets, only
their acquired cost.
Adopting a marking to market approach—that is, reporting assets at their
current market value—provides better information to management and
investors.
Downside is the difficulty in estimating market values of assets.
When both the liabilities and assets of a firm are reported at their current
market value, their difference represents the true market value of
shareholders’ equity.
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3.4 The Income Statement and the Statement of Retained Earnings
A. The Income Statement
The profitability of a firm for any reporting period is measured in the financial
statement. The basic identity is shown in Equation 3.3.
Revenues represent the value of the products and services sold by the firm,
and they include both cash and credit sales.
Expenses range from the cost of producing goods for sale and asset utilization
costs such as depreciation or amortization.
Net income is the difference between the firm’s revenues and expenses.
B. Depreciation, Amortization, and Other Income Statement Accounts
Depreciation is the writing off of the cost of any physical asset like plant or
machinery over its lifetime. This is a noncash expense.
Depreciation expense reduces a firm’s taxable income as well as the firm’s
taxes, while increasing the cash flow available to shareholders.
Firms can use one of two methods of depreciating an asset: the straight-line
method and the accelerated depreciation method. Firms are allowed to use one
approach for internal purposes and another for tax purposes.
Firms prefer the accelerated depreciation method for tax purposes because it
allows the firm to write off larger amounts of the cost of an asset over a
shorter period.
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Amortization expenses are related to the writing off of the value of intangible
assets like goodwill, patents, and licenses. It is also a noncash expense like
depreciation.
Nonrecurring expenses are associated with the closing down of unprofitable
operations or the restructuring of a firm’s operations.
Extraordinary items refer to income or expenses associated with events that
are not expected to happen on a regular basis.
C. Bottom-Line Accounts
The first bottom-line income figure that would be of interest to shareholders
and creditors is earnings before interest, taxes, depreciation, and
amortization (EBITDA), which is the earnings generated from operations
prior to the recognition of expenses not directly connected to the production of
the products.
After netting out the expenses related to depreciation and amortization, we
arrive at earnings before interest and taxes (EBIT).
The next important income line is earnings before taxes (EBT) and
represents the taxable income for the period.
Finally, subtracting taxes from EBT yields net income, or net income after
taxes. This amount tells us the amount available to management to pay
dividends, pay off debt, or reinvest in the firm.
D. The Statement of Retained Earnings
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This financial statement shows the changes in this account from one period to
the next.
This account will show changes whenever a firm reports a loss or profit and
when a cash dividend is declared.
3.5 Cash Flows
A. Net Income versus Cash Flows
While accountants focus on net income, shareholders are more interested in
net cash flows.
Net income and cash flows are not the same because of the presence of
noncash revenues and expenses.
Equation 3.4 shows how we can derive the net cash flows from operating
activities (NCFOA) from net income. A simplified version of Equation 3.4 is
used when the only significant non cash items are depreciation and
amortization. Equation 3.5 shows this.
B. The Statement of Cash Flows
This financial statement helps to measure the cash outflows and the cash
inflows generated during any period.
The statement is broken down into three parts to identify the cash flows
resulting from operating activities, investing activities, and financing
activities.
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Operating activities: Cash flows result from producing and selling goods and
services. Cash inflows result from selling the products and services from the
firm. Cash outflows are tied to the purchase of raw materials, inventory,
salaries and wages, utilities, rent, interest and other related expenses.
Investing activities: Cash inflows and outflows arise out of the acquisition and
sale of real assets necessary to operate the business. It can also result from the
buying and selling of financial assets such as bonds and stocks, making and
collecting loans, and selling and settling insurance contracts.
Financing activities: When a firm issues debt or equity securities and borrows
money from banks or other lenders, it produces cash inflows. If the firm pays
interest or dividends on the investor’s funds, or pays off debt or purchases
treasury stock, the firm has cash outflows.
The sum of the cash flows from these three activities measures the net cash
flows of the firm during a given period and is the bottom line of this financial
statement.
3.6 Tying the Financial Statements Together
The role of the balance sheet includes the following:
The balance sheet brings all the financial statements together, summarizing
the financing and investment activities of the firm at a point in time.
It recognizes the changes in the company’s financial position since the last
reporting period that result from new activities or discontinued activities.
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It identifies to shareholders the impact on the owners’ equity account of all the
transactions that the firm was involved in since the last reporting period and
recognized in the income statement and statement of retained earnings.
3.7 Federal Income Tax
A. Corporate Income Tax Rates
The federal income tax schedule for the year 2007 is shown in Exhibit 3.6.
It is a progressive tax schedule with rates ranging from 15 to 39 percent. This
means the higher a firm’s taxable income, the higher the tax liability.
B. Average versus Marginal Tax Rates
The average tax rate is the total taxes paid divided by taxable income for the
period.
The marginal tax rate is the tax rate that is paid on the last dollar earned or the
next dollar earned.
C. Tax Treatment of Dividends and Interest Payments
The current tax code in the United States allows interest payments on debt
issued by firms to be tax deductible.
Dividends paid on the firm’s preferred stock or common stock is not
deductible for tax purposes and is paid from after-tax income.
The result is a lower cost of debt financing relative to the cost of equity
financing.
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II. Suggested and Alternative Approaches to the Material
This chapter focuses on the four important financial statements that every firm uses to provide
information about the financial condition of the company to both management and investors. In
addition, there are discussions on the generally accepted accounting principles (GAAP) and
International GAAP. The chapter also overviews market value accounting.
Many instructors may choose to cover this chapter in detail. This allows the students to
better understand the reporting of accounting information before moving on to the analysis of
financial statements in Chapter 4. This material becomes even more critical when the majority of
students taking the required first course in Finance are not Finance or Accounting majors.
Other instructors may choose to skim through the topics in this chapter if they feel that
their students are adequately prepared to tackle the topics in the next couple of chapters. Or they
can choose to skip this chapter altogether if their students have a strong enough accounting
background. This alternative will be especially helpful if this is a second Finance course, and it
will allow the instructor to cover other material.
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III. Summary of Learning Objectives
1. Discuss generally accepted accounting principles (GAAP) and their importance to
the economy.
GAAP are a set of authoritative guidelines that define accounting practices at a particular
point in time. Thus, GAAP principles determine the rules for how a company maintains
its accounting system and how it prepares financial statements. Accounting standards are
important because without them, each firm could develop its own unique accounting
practices, which would make it difficult for stakeholders to monitor the firm’s true
performance or compare the performance of different firms. The result would be a loss of
confidence in the accounting system and the financial reports it produces.
2. Know the balance sheet identity, and explain why a balance sheet must balance.
A balance sheet provides a summary of a firm’s financial position at a particular point in
time. The balance sheet identifies the productive resources (assets) that a firm uses to
generate income, as well as the sources of funding from creditors (liabilities) and owners
(shareholders’ equity) that were used to buy the assets. The balance sheet identity is:
Total assets = Total liabilities + Total stockholders’ equity. Total stockholders’ equity
represents ownership in the firm and is the residual claim of the owners after all other
obligations to creditors, employees, and vendors have been paid. The balance sheet must
always balance because the owners get what is left over after all creditors have been paid
—that is, Total stockholders’ equity = Total assets – Total liabilities.
3. Describe how market-value balance sheets differ from book-value balance sheets.
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Book value is the amount a firm paid for its assets at the time of purchase. The current
market value of an asset is the amount that a firm would receive for the asset if it were
sold on the open market (not in a forced liquidation). Most managers and investors are
more concerned about what a firm’s assets can earn in the future than about what the
assets cost in the past. Thus, balance sheets marked to market are more helpful in
showing a company’s true financial condition than balance sheets based on historical
costs. Of course, the problem with marked-to-market balance sheets is that it is difficult
to estimate market values for some assets and liabilities. In addition, there are fears that
the management of some firms may be tempted to manipulate the estimates of market
value to favorably distort their firm’s true financial picture.
4. Identify the basic equation for the income statement and the information it
provides.
An income statement is a snapshot that provides a picture of the firm’s profit or loss for a
period of time, usually a month, quarter, or year. The income statement identifies the
major sources of revenues generated by the firm and the corresponding expenses that
were needed to generate those revenues. The equation for the income statement is: Net
income = Revenues - Expenses. If revenues exceed expenses, the firm generates a net
profit for the period. If expenses exceed revenues, the firm generates a net loss. Net profit
or income is the most comprehensive accounting measure of a firm’s performance.
5. Explain the difference between cash flows and accounting income.
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Cash flows represent the movement of cash within the firm. Cash flows are important in
finance because the value of any asset—stocks, bonds, or a business—is determined by
the future cash flows generated by the asset. Accounting profits, in contrast, are
calculated according to GAAP in order to determine taxes and to report to stakeholders in
a consistent manner. Accounting profits include noncash revenues (such as prepaid rent)
and noncash expenses (such depreciation), whereas cash flows do not include these items.
6. Explain how the four major financial statements discussed in this chapter are
related.
The four financial statements discussed in the chapter are the balance sheet, the income
statement, the statement of cash flows, and the statement of retained earnings. The key
financial statement that ties the other three statements together is the statement of cash
flows, which summarizes changes in the balance sheet from the beginning of the year to
the end. These changes reflect information in the income statement and in the statement
of retained earnings.
7. Discuss the difference between the average and marginal tax rates.
The average tax rate is total taxes divided by taxable income. It takes into account the
taxes paid at all levels of income, and therefore it will be lower than the marginal tax rate,
which is the rate that is paid on the last dollar of income earned. However, for very high
income earners, these two rates will be close to equal. When companies are making
financial decisions, they use the marginal tax rate, because new projects are expected to
generate additional cash flows, which will be taxed at the firm’s marginal tax rate.
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IV. Summary of Key Equations
Equation Description Formula
3.1Balance sheet
identityTotal assets = Total liabilities + Total stockholders’ equity
3.2 Net working capital Net working capital = Total current assets – Total current liabilities
3.3Income statement
identityNet income = Revenues - Expenses
3.4Net cash flow from
operating activitiesNCFOA = Net income – Noncash revenues + Noncash expenses
3.5Net cash flow from
operating activitiesNCFOA = Net income + Depreciation and amortization
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V. Before You Go On Questions and Answers
Section 3.1
1. What types of information does a firm’s annual report contain?
A firm’s annual report is typically divided into three sections: financial tables with an
accompanying verbal explanation of the firm’s performance over the past year; a
corporate public relations section discussing the firm’s operations, and the audited
financial statements (balance sheet, income statement, statement of cash flows, and
statement of retained earnings).
2. What is the realization principle, and why may it lead to a difference in the timing of
when revenues are recognized on the books and cash is collected?
According to the realization principle, revenue should only be recognized when the
earning process is completed and the exchange of goods or services can be determined by
an arm’s length transaction. Although this principle works in theory, it still does not
specify whether this is the point when the goods are ordered, when they are shipped, or
when the payment is actually received from the customer. Also, not many purchases are
paid for in cash any more. Therefore, even if the transaction is recognized at the point at
which the customer receives the goods, the actual cash flow might not occur until days
later (depending what the terms are).
Section 3.2
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1. What is net working capital? Why might a low value for this number be considered
undesirable?
Net working capital is the difference between total current assets and total current
liabilities. A low value for this number is undesirable, for it indicates that the company
may not have enough cash on hand to cover its immediate expenses.
2. Explain the accounting concept behind depreciation.
Depreciation in accounting is a noncash expense that helps to allocate the cost of an item
over its expected life. It reflects the estimated decrease in the value of an asset due to
wear and tear and obsolescence.
3. What is treasury stock?
Treasury stock is the stock that the company purchased back from its investors. These
shares do not pay dividends, have no voting rights, and should not be included in shares-
outstanding calculations.
Section 3.3
1. What is the difference between book value and market value?
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Book value is the price you paid for a particular asset. This price does not change as long
as you own the asset. On the other hand, market value is the price at which you can sell
an asset today, as it takes into account how much it can earn in the future.
2. What are some objections to the preparation of marked-to-market balance sheets?
Marked-to-market balance sheets list the firm’s assets and liabilities at their current
market prices. Even though a balance sheet constructed with actual market values might
paint a more accurate picture of the company’s financial situation, current values are
difficult to estimate, and a lot of the complicated models are potentially open to abuse.
Therefore, as of the present, the norm is to use book values.
Section 3.4
1. How do you compute net income?
Net income is calculated as revenues minus expenses. It is the most comprehensive
accounting measure of a company’s performance because it reflects the firm’s
accomplishments (revenues) relative to its efforts (expenses) during a time period.
2. What is EBITDA, and what does it measure?
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. EBIT
is defined as earnings before taxes and interest. The main difference between these two
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figures is that EBITDA shows the income earned purely from operations and reflects how
efficiently a firm can manufacture and sell its products without taking into account the
cost of the productive asset base.
3. What accounting events trigger changes to the retained earnings account?
Two events will trigger changes to the retained earnings account: (1) a firm’s report of a
net income or loss and (2) the board of directors’ declaration of a cash dividend.
Section 3.5
1. What is the difference between accounting profits and net cash flows?
Accounting profits and net cash flows are not the same because as accountants prepare
the financial statements, they do not simply count the cash coming in and cash going out.
The accounting profits are calculated based on the matching principle and other
accounting rules that adhere to GAAP, but are not necessarily based on cash transactions.
2. Should a firm only consider depreciation and amortization expenses when calculating the
net cash flow? Explain.
Depreciation and amortization are taken into account when calculating both the net cash
flows and the net income. Both depreciation and amortization get treated as expenses on
the income statement, and they are subtracted from revenues to derive net income. When
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calculating net cash flows, depreciation and amortization are added to net income, as both
of these are noncash expenses.
3. Explain the difference between financing and investing activities.
Investing activities refer to the buying and selling of long-term assets, whereas financing
activities refer to those activities where cash is obtained from, or repaid to, creditors or
owners (shareholders).
Section 3.6
1. Explain how the four financial statements are related.
The four financial statements are linked together as follows: the ending cash balance
from the statement of cash flows is used as the cash balance on the balance sheet, and the
net income reported in the income statement is transferred to retained earnings on the
balance sheet. So as you can see, the balance sheet is the one financial statement that ties
all four statements together.
Section 3.7
1. Why is it important to consider the consequences of taxes when financing a new project?
When financing a new project, it is important to consider the consequences of taxes
because ultimately they have a significant impact on company’s income.
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2. Which type of tax rate, marginal or average, should be used in analyzing the expansion of
a product line, and why?
When analyzing the expansion of a product line, the marginal tax rate should be the type
to consider because it is the amount paid on an additional dollar of income earned. Since
expansion of a product line is expected to generate new cash flows, the company will be
taxed based on the additional earnings. Average tax rate is not as relevant when making
financing decisions because it is simply the total taxes paid divided by taxable income.
3. What are the tax implications of a decision to finance a project using debt rather than new
equity?
The difference between debt financing and financing through new equity is in the tax
treatment of interest and dividends. While interest payments on debt are tax-deductible
business expenses, dividends paid to common or preferred stockholders are not
deductible.
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VI. Self-Study Problems
3.1 The going -concern assumption of GAAP implies that the firm:
a. is going under and needs to be liquidated at historical cost.
b. will continue to operate and its assets should be recorded at historical cost.
c. will continue to operate and that all assets should be recorded at their cost rather
than at their liquidation value.
d. is going under and needs to be liquidated at liquidation value.
Solution: c
One of the key assumptions under GAAP is the going concern assumption, which
states that the firm (c) will continue to operate and that all assets should be
recorded at their cost rather than at their liquidation value.
3.2 The Ellicott City Ice Cream Company management has just completed an assessment of
its assets and liabilities and has come up with the following information. It has total
current assets worth $625,000 at book value and $519,000 at market value. In addition,
its long-term assets include plant and equipment valued at market for $695,000, while
their book value was $940,000. The company’s total current liabilities are valued at
market for $543,000, while their book value is $495,000. Both the book value and the
market value of its long-term debt is $350,000. If the company’s total assets are equal to
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a market value of $1,214,000 (book value of $1,565,000), what are the book value and
market value of its shareholders’ equity?
Solution: The book value and market value are as follow (in thousands of dollars):
Assets
Book
Value
Market
Value Liabilities
Book
Value
Market
Value
Total current assets $ 625 $ 519 Total current liabilities $ 495 $ 543
Fixed assets 940 695 Long-term debt 350 350
Stockholders’ equity 720 321
Total assetsS $1,565 $1,214 Total liabilities and
stockholders’ equity
$1,565 $1,214
3.3 Depreciation and amortization expenses are:
a. part of current assets on the balance sheet.
b. after-tax expenses that reduce a firm’s cash flows.
c. long-term liabilities that reduce a firm’s net worth.
d. noncash expenses that cause a firm’s after-tax cash flows to exceed its net
income.
Solution: d
Depreciation and amortization expenses are (d) noncash expenses that cause a
firm’s after-tax cash flows to exceed its net income.
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3.4 You are given the following information about Clarkesville Plumbing Company.
The company’s annual report on December 31, 2008, showed that during the year
its revenues totaled $896, current assets $121, current liabilities $107,
depreciation expenses $75, costs of goods sold $365, and interest expenses $54.
The company is in the 34 percent tax bracket. Calculate its net income by setting
up an income statement.
Solution: Clarkesville’s income statement and net income are as follows:
Clarkesville Plumbing CompanyIncome Statement as of December 31, 2008
Amount
Revenues $896.00
Costs 365.00
EBITDA $531.00
Depreciation 75.00
EBIT $456.00
Interest 54.00
EBT $402.00
Taxes (34%) 136.68
Net income $265.32
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3.5 The Huntington Rain Gear Company had $633,125 in taxable income in the year ending
September 30, 2008. Calculate the company’s tax using the tax schedule in Exhibit 3.6.
Solution: Huntington’s tax bill is calculated as follows:
Tax rate Income Tax
15% $50,000 $ 7,500
25 (75,000–50,000) 6,250
34 (100,000–75,000) 8,500
39 (335,000–100,000) 91,650
34 (633,125–335,000) 101,363
Total taxes payable $215,263
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VII. Critical Thinking Questions
3.1 What is a major reason for the accounting scandals in recent years? How do firms attempt
to meet Wall Street analysts’ projection of earnings?
Most people believe that managers’ short-term focus is driven by Wall Street’s demand
that companies meet or beat the earnings forecasted by stock analysts. Rather than report
the actual earnings of the firm, managers try to meet the market’s expectations by starting
with the bottom-line number and backing into a sales figure. Thus, the sales may be
consistent with the reported earnings figure, but do not represent the true revenue
generated by the firm.
3.2 Why are taxes and the tax code important for managerial decision making?
Understanding the tax code is critical to finance managers, since most decisions are made
on an after-tax basis. Furthermore, taxes affect any valuation analysis and also determine
the bottom-line figure that is of concern to shareholders and managers.
3.3 Identify the five fundamental principles of GAAP and explain briefly their importance.
The assumption of arm’s length transaction assumes that all business transactions
between two parties are made rationally from an economic perspective and both parties
will make the deal that provides them the best value. The cost principle calls for the
recognition of all accounting transactions at historic cost, or the amount paid or received
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when the transaction was concluded at arm’s length. The realization principle implies
that revenue should be recognized only at the time of the sale. The matching principle
dictates that revenue is first recognized and then is matched with the costs incurred in
producing the revenue. Finally, the going concern assumption implies that the firm will
continue to operate and that all assets should be recorded at their cost rather than at their
liquidation value.
3.4 Explain why firms prefer to use accelerated depreciation methods over the straight-line
method for tax purposes.
When a firm uses accelerated depreciation, the depreciation expense is higher than with
the straight-line method. This reduces the taxable income and the amount of tax paid by
the firm. As a result of this higher noncash expense, the firm’s cash flow is higher.
3.5 What is treasury stock? Why do firms have treasury stock?
Any shares repurchased by the company in the open market are recorded as treasury
stock in the shareholders’ equity account in the balance sheet. The most common reason
for firms doing this is to reduce the number of shares outstanding in the market when the
management believes that its firm’s stock is undervalued. This reduction in the number of
shares outstanding is expected to boost the share price.
3.6 Define book-value accounting and market- value accounting.
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Book-value accounting implies that all assets and liabilities are recorded and reported at
the historical cost when they were acquired. Market-value accounting requires that all
assets and liabilities are reported at their current market value.
3.7 Compare and contrast depreciation expense and amortization expense.
Depreciation expense is the amount by which a firm’s fixed assets are written down in a
period during which the assets are utilized for generating cash flows. Amortization is the
amount by which intangible assets like goodwill, patents, license, copyrights, and
trademarks are written down in any period that they are utilized by the firm to generate
benefits. Both depreciation and amortization are noncash expenses that will serve to
boost the firm’s after-tax cash flows.
3.8 Why are retained earnings not considered an asset of the firm?
Retained earnings are part of shareholders’ equity that has already been utilized by the
company. It is a liability of the company and corresponds to a claim by the firm’s
shareholders. The retained earnings reported on the balance sheet have already been
allocated by the company among various assets and hence are not available for current or
future uses. New retained earnings have to be generated to provide for new uses!
3.9 How does net cash flow differ from net income and why?
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Net income or profit after taxes is an accounting figure that includes both cash and
noncash expenses. In addition, revenues are recognized before they are collected and
expenses are recognized before they are paid. Net cash flow, on the other hand, only
recognizes cash inflows and cash outflows that have occurred. Accrual-based accounting
causes a time lag between the point when revenues and expenses are recorded and the
point when the cash flows actually occur.
3.10 What is the statement of cash flows, and what is its role?
This financial statement records both the cash inflows and cash outflows for a period of
time. Thus, it reports the changes in the cash position of a firm between successive
accounting periods.
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VIII. Questions and Problems
BASIC
3.1 Balance sheet: Given the following information about the Elkridge Sporting Goods, Inc.,
construct a balance sheet for the period ending June 30, 2008. The firm had cash and
marketable securities of $25,135, accounts receivables of $43,758, inventory of
$167,112, net fixed assets of $325,422, and other assets of $13,125. It had accounts
payables of $67,855, notes payables of $36,454, long-term debt of $223,125, and
common stock of $150,000. How much retained earnings does the firm have?
Solution:
Assets Book Value Liabilities Book Value
Cash $ 25,135 Accounts payables $ 67,855
Accounts receivable 43,758 Notes payables 36,454
Inventories 167,112
Total current assets $236,005 Total current liabilities $104,309
Net fixed assets 325,422 Long-term debt 223,125
Other assets 13,125 Common stock 150,000
Retained earnings 97,118
Total assets $574,552 Total liabilities and
stockholders’ equity
$574,552
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3.2 Inventory accounting: Differentiate between FIFO and LIFO.
Solution: FIFO (first in, first out) refers to the practice of firms, when making sales, assuming
that the inventory that came in first (at a lower price) is being sold first. LIFO (last in,
last out) implies that a firm is selling the higher cost, newer inventory first, leaving
the lower cost, older inventory on the balance sheet.
3.3 Inventory accounting: Explain how the choice of FIFO versus LIFO can affect a firm’s
balance sheet and income statement.
Solution: FIFO makes sense during times of rising prices because it allows the firm to eliminate
the lower priced inventory first, resulting in higher profit margin. This allows the firm
to leave higher valued inventory on the balance sheet. During inflationary times, a
firm using LIFO would see a lower profit margin and lower values of inventory on
the balance sheet. It is important that anyone who is analyzing firms using different
accounting methods on inventory recognize the impact on the bottom line (profit
margin and net income) and on current assets.
3.4 Market-value accounting: How does the use of market-value accounting help
managers?
Solution: Market-value accounting of both assets and liabilities allows managers to have a truer
picture of their company’s financial condition and to do a better job of estimating
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cash flows that the assets would generate. However, marking-to-market is not as easy
as it sounds because of the difficulties involved in coming up with the correct market
value of current assets and liabilities.
3.5 Working capital: Laurel Electronics reported the following information at its annual
meetings. The company had cash and marketable securities worth $1,235,455, accounts
payables worth $4,159,357, inventory of $7,121,599, accounts receivables of $3,488,121,
notes payable worth $1,151,663, and other current assets of $121,455. What is the
company’s net working capital?
Solution:
Total current assets = $1,235,455 + $3,488,121 + $7,121, 599 + 121,455
= $11,966,630
Total current liabilities = $4,159,357 + $1,151,663
= $5,311,020
Net working capital = $11,966,630 - $5,311,020 = $6,655,610
3.6 Working capital: The financial information for Laurel Electronics referred to in Problem
3.5 is all book value. Suppose marking-to-market reveals that the market value of the
firm’s inventory is 20 percent below its book value and its receivables are 25 percent
below its book value. The market value of its current liabilities is identical to the book
value. What is the firm’s net working capital using market values? What is the percent
change in net working capital?
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Solution:
Market value of inventory = $7,121,599 * 0.80 = $5,697,279
Market value of receivables = $3,488,121 * 0.75 = $2,616,091
Total current assets = $1,235,455 + $2,616,091 + $5,697,279 + 121,455
= $9,670,280
Total current liabilities = $4,159,357 + $1,151,663 = $5,311,020
Net working capital = $9,670,280 - $5,311,020 = $4,359,260
3.7 Income statement: The Oakland Mills Company has disclosed the following financial
information in its annual reports for the period ending March 31, 2008. It produced sales
of $1.45 million, had cost of goods sold to the tune of $812,500, depreciation expenses of
$175,000, and interest expenses of $89,575. Assume that the firm has a tax rate of 35
percent. What is the company’s net income? Set up an income statement to answer the
question.
Solution:
Amount
Revenues $1,450.000.00
Costs 812,500.00
EBITDA $ 637,500.00
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Depreciation 175,000.00
EBIT $ 462,500.00
Interest 89,575.00
EBT $ 372,925.00
Taxes (35%) 130,523.75
Net income $ 242,401.25
3.8 Cash flow: Describe the organization of the statement of cash flows.
Solution: The statement of cash flows identifies the cash inflows and cash outflows of the firms
for a specified period. This allows one to estimate the net cash flows from operations.
This financial statement is organized to report the cash flows resulting from the three
basic activities in any firm—operating, investing, and financing. See Exhibit 3.4 for
an example. The cash flows from operations are the results of netting all revenues
and expenses that result from the operating activities of the firm. Buying and selling a
firm’s assets lead to cash flows from investing activities. Cash flows from financing
activities arise from the firm borrowing from its investors and/or making payments to
its lenders and shareholders.
3.9 Cash flows: During 2008, Towson Recording Company increased its investment in
marketable securities by $36,845, funded fixed assets acquisitions of $109,455, and had
marketable securities of $14,215 mature. What is the net cash used in investing activities?
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Solution:
Long-Term Investing Activities
Net property, equipment, and other assets $(109,455.00)
Net acquisitions and dispositions 0.00
Investments in marketable securities (22,630.00)
Net cash used in investing activities $(132,085.00)
3.10 Cash flows: Caustic Chemicals identified the following cash flows as significant in its
meeting with analysts. During the year, it had repaid existing debt of $312,080 and raised
additional debt capital of $650,000. It also repurchased stock in the open market for a
total of $45,250. What is the net cash provided by financing activities?
Solution:
Financing Activities
Loan repayment $(312,080)
Increase in long-term debt 650,000
Purchase of treasury stock (45,250)
Net cash provided by financing activities $ 292,670
3.11 Cash flow: Identify and explain the noncash expenses that a firm may incur.
Solution: A firm may have several items on its income statement that did not result in any cash
outflow to the firm. The two largest are depreciation expenses and amortization
expenses. Other noncash expenses include deferred taxes, wages, and depletion
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charges, which is similar to depreciation and used for natural resource assets. Prepaid
expenses also fit into this category as they represent expenses to the firm that are yet
to be paid out.
3.12 Tax: Define average tax rate and marginal tax rate.
Solution: The average tax rate is defined as the total taxes paid divided by taxable income.
The marginal tax rate, meanwhile, represents the tax rate that is paid on the last
dollar of income earned, or the rate that will be paid on the next dollar earned.
3.13 Tax: What is the relevant tax rate to use when making financial decisions? Explain why.
Solution: Managers need to use the marginal tax rate for making financial decisions. This is
because any additional cash flows that result from a firm’s new projects will be taxed
at the marginal tax rate. Thus, this is the appropriate rate to use.
3.14 Tax: Manz Property Management Company announced that in the year ended June 30,
2008, its earnings before taxes amounted to $1,478,936. Calculate its taxes using Exhibit
3.6.
Solution:
Earnings before tax = $1,478,936
Tax rate Income Tax
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15% $0 to $50,000 $ 7,500.00
25 50,001 75,000 6,250.00
34 75,001 100,000 8,500.00
39 100,001 335,000 91,650.00
34 335,001 10,000,000 388,938.24
35 10,000,001 15,000,000
38 15,000,001 18,333,333
35 More than $18,333,333
Total taxes payable $502,838.24
INTERMEDIATE
3.15 Balance sheet: Tim Dye, the chief financial officer of Blackwell Automotive, Inc., is
putting together this year’s financial statements. He has gathered the following
information. The firm had a cash balance of $23,015, accounts payable of $163,257,
common stock of $313,299, retained earnings of $512,159, inventory of $212,444,
goodwill and other assets equal to $78,656, net plant and equipment of $711,256, and
short-term notes payable of $21,115. It also has accounts receivables of $141,228 and
other current assets of $11,223. What amount of long-term debt does Blackwell
Automotive have?
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Solution:
Assets
Liabilities and Stockholders’
Equity
Cash and marketable
securities
$ 23,015 Accounts payable and accruals $ 163,257
Accounts receivable 141,258 Notes payable 21,115
Inventories 212,444
Other current assets 11,223
Total current assets $ 387,940 Total current liabilities $ 184,372
Net plant and equipment 711,256 Long-term debt 168,022
Goodwill and other assets 78,656 Total liabilities $ 352,394
Common stock 313,299
Retained earnings 512,159
Total common equity $ 825,458
Total assets $1,177,852 Total liabilities and
stockholders’ equity
$1,177,852
3.16 Balance sheet: Refer to the information for Blackwell Automotive in Problem 3.15.
What level of working capital does Blackwell Automotive have?
Solution:
Net working capital = Total current assets – Total current liabilities
= $387,940 – $184,372 = $203,568
3.17 Working capital: Mukhopadhya Network Associates has a current ratio of 1.60. Its
current assets are equal to $1,233,265, its accounts payables are $419,357, and its notes
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payables are $351,663. Its inventory is currently at $721,599. The company plans to raise
funds in the short-term debt market and invest the entire amount in additional inventory.
How much can their notes payable increase without lowering their ratio of current assets
to current liabilities to below 1.50?
Solution:
Let x be the amount raised through notes payables.
New current liabilities = $184,372 + x
New current assets = $387,940 + x
Thus the firm can add up to $222,764 in inventory by raising money through notes
payable without changing the ratio of current assets to current liabilities to more than
1.50. (This ratio of current assets to current liabilities is known as the current ratio and
will be discussed in the next chapter.)
3.18 Market value: Reservoir Bottling Co. reported to shareholders the following
information. It has total current assets worth $237,513 at book value and $219,344 at
market value. In addition, its long-term assets include plant and equipment valued at
market for $343,222, while their book value is $362,145. The company’s total current
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liabilities are valued at market for $134,889, while their book value is $129,175. Both the
book value and the market value of its long-term debt is $144,000. If the company’s total
assets are equal to a market value of $562,566 (book value of $599,658), what is the
difference in the book value and market value of its stockholders’ equity?
Solution:
Assets
Book
Value
Market
Value Liabilities
Book
Value
Market
Value
Total current assets $237,513 $219,344 Total current liabilities $129,175 $134,889
Net fixed assets 362,145 343,222 Long-term debt 144,000 144,000
Other assets 0 0 Common stock 326,483 283,677
Total assets $599,658 $562,566 Total liabilities and
stockholders’ equity
$599,658 $562,566
Change in value of equity = $283,677 – $326,483 = $(42,806)
3.19 Income statement: Nimitz Rental Company provided the following information to its
auditors. For the year ended March 31, 2008, the company had revenues of $878,412,
general and administrative expenses of $352,666, depreciation expenses of $131,455,
leasing expenses of $108,195, and interest expenses equal to $78,122. If the company’s
tax rate was 34 percent, what is its net income after taxes?
Solution:
Nimitz Rental CompanyIncome Statement as of March 31, 2008 (in $ 000s)
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Amount
Net sales $878,412
Selling and administrative expenses 352,666
Leasing expenses 108,195
EBITDA $417,551
Depreciation 131,455
EBIT $286,096
Interest expense 78,122
EBT $207,974
Taxes (34%) 70,711
Net income $137,263
3.20 Income statement: Sosa Corporation recently reported an EBITDA of $31.3 million and
$9.7 million of net income. The company has $6.8 million interest expense, and the
corporate tax rate is 35 percent. What was the company’s depreciation and amortization
expense?
Solution:
Amount
EBITDA $31,300,000.00
Less: Depreciation and amortization 9,576,923.08
EBIT $21,723,076.92
Interest 6,800,000.00
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EBT $14,923,076.92
Taxes (35%) 5,223,076.92
Net income $ 9,700,000.00
3.21 Income statement: Fraser Corporation has announced that its net income for the year
ended June 30, 2008, is $1,353,412. The company had an EBITDA of $ 4,967,855, and
its depreciation and amortization expense was equal to $1,112,685. The company’s tax
rate is 34 percent. What is the amount of interest expense for Fraser Corporation?
Solution:
Amount
EBITDA $4,967,855.00
Depreciation 1,112,685.00
EBIT $3,855,170.00
Interest 1,804,545.76
EBT $2,050,624.24
Taxes (34%) 697,212.24
Net income $1,353,412.00
3.22 Income statement: Carmichael Hobby Shop has an EBITDA of $512,725.20, an EBIT
of $362,450.20, and a cash flow of $348,461.25. What is the net income after taxes for this
firm?
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Solution:
Amount
Revenues $1,314,680.00
Costs 801,954.80
EBITDA $512,725.20
Depreciation 150,275.00
EBIT $362,450.20
Interest 62,168.00
EBT $300,282.20
Taxes (34%) 102,095.95
Net income $198,186.25
3.23 Retained earnings: Columbia Construction Company earned $451,888 during the year
ended June 30, 2008. After paying out $225,794 in dividends, the balance went into
retained earnings. If the firm’s total retained earnings were $846,972, what was the level
of retained earnings on its balance sheet on July 1, 2007?
Solution:
Columbia Construction CompanyRetained Earnings for 2008 (in $000s)
Balance of retained earnings, July 1, 2007 $ 621,178.00
Add: Net income, 2008 451,588.00
Less: Dividends to common stockholders (225,794.00)
Balance of retained earnings, June 30, 2008 $ 846,972.00
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3.24 Cash flow: Refer to the information given in Problem 3.19. What is the cash flow for
Nimitz Rental?
Solution:
Cash flow from operation = Net income + Depreciation
= $137,263 + $131,455
= $268,718
3.25 Tax: Mount Hebron Electrical Company’s financial statements indicated that the
company had an EBIT of $718,323. Its interest rate on debt of $850,000 was 8.95
percent. Calculate the amount of taxes the company is likely to owe. What are the
marginal and the average tax rates for this company?
Solution:
EBIT $718,323.00
Interest 76,075.00
EBT $642,248.00
Tax rate Income Tax
15% $0 to $50,000 $ 7,500.00
25 50,001 75,000 6,250.00
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34 75,001 100,000 8,500.00
39 100,001 335,000 91,650.00
34 335,001 10,000,000 104,464.32
35 10,000,001 15,000,000
38 15,000,001 18,333,333
35 More than $18,333,333
Total taxes payable $218,364.32
Marginal tax rate = 34%
Average tax rate = Total taxes / Taxable income
= $218,364.22 / $642,248
= 34%
ADVANCED
3.26 Income statement: The Centennial Chemical Corp. announced that for the period ending
March 31, 2008, it had earned income after taxes worth $5,330,275 on revenues of
$13,144,680. The company’s costs (excluding depreciation and amortization) amounted
to 61 percent of sales, and it had interest expenses of $392,168. What is the firm’s
depreciation and amortization expense if its tax rate was 34 percent?
Solution:
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Amount
Revenues $13,144,680.00
Costs 8,018,254.80
EBITDA $ 5,126,425.20
Depreciation 540,275.00
EBIT $ 4,586,150.20
Interest 392,168.00
EBT $ 4,193,982.20
Taxes (34%) 1,425,953.95
Net income $ 5,330,275.00
3.27 Retained earnings: Eau Claire Paper Mill, Inc., had, at the beginning of the fiscal year,
April 1, 2007, retained earnings of $323,325. During the year ended March 31, 2008, the
company produced net income after taxes of $713,445 and paid out 45 percent of its net
income as dividends. Construct a statement of retained earnings and compute the year-
end balance of retained earnings.
Solution:
Balance of retained earnings, April 1, 2007 $ 323,325.00
Add: Net income, 2008 713,445.00
Less: Dividends to common stockholders (321,050.25)
Balance of retained earnings, March 31, 2008 $ 715,719.75
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3.28 Taxes: Menomonie Casino Company earned $23,458,933 before interest and taxes for
the fiscal year ending March 31, 2008. If the casino had interest expenses of $1,645,123,
calculate its tax burden using Exhibit 3.6. What are the marginal and the average tax rates
for this company?
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Solution:
EBIT $23,458,933.00
Interest 1,645,123.00
EBT $21,813,810.00
Tax rate Income Tax
15% $0 to $50,000 $ 7,500.00
25 50,001 75,000 6,250.00
34 75,001 100,000 8,500.00
39 100,001 335,000 91,650.00
34 335,001 10,000,000 3,286,100.00
35 10,000,001 15,000,000 1,750,000.00
38 15,000,001 18,333,333 1,266,666.54
35 More than $18,333,333 1,218,166.95
Total taxes payable $7,634,833.49
Marginal tax rate = 35%
Average tax rate = Total taxes / Taxable income
= $7,634,833.49 / $21,813,810
= 35%
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3.29 Cash flows: Vanderheiden Hog Products Corp. provided the following financial
information for the quarter ending June 30, 2008:
Net income: $189,425
Depreciation and amortization: $63,114
Increase in receivables: $ 62,154
Increase in inventory: $57,338
Increase in accounts payables: $37,655
Decrease in other current assets: $27,450
What is this firm’s cash flow from operating activities during this quarter?
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Solution:
Operating Activities
Net income $189,425
Additions (sources of cash)
Depreciation and amortization 63,114
Increase in accounts payable 37,655
Decrease in other current assets 27,450
Increase in accrued income taxes 0
Subtractions (uses of cash)
Increase in accounts receivable (62,154)
Increase in inventories (57,338)
Net cash provided by operating activities $198,152
3.30 Cash flows: Analysts following the Tomkovick Golf Company were given the following
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