Chapter 2 - Financial background: A Review of Accounting, Financial Statements and Taxes

The Nature of Financial Statements

Numerical representations of a firm’s activities for an accounting period– A picture of activities within the firm and

between the firm and the outside– But can be counterintuitive

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Accounts Receivable

Most sales are on credit

Seller receives a promise of later payment, rather than immediate cash

The seller records an account receivable as an asset

Net income may not = cash flow

Depreciation

Proration of an asset’s cost over its service life

Can be straight lined or accelerated

Cost recorded on the income statement does not = cash spent

The Nature of Financial Statements

Three Financial Statements– Income statement– Balance sheet– Statement of cash flows

Generated from the income statement and balance sheet

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The Accounting System

A firm’s financial books are a collection of records in which money transactions are recorded– Double entry system– Accounting periods and closing the books– Implications– Stocks and flows

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Table 2-1 A Typical Income Statement

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The Income Statement

Sales

Cost and Expenses– Costs of Goods Sold– Expense– Depreciation

Gross margin

Earnings before interest and taxes (EBIT)

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The Income Statement

Earnings Before Tax, and Tax

Net Income

Terminology:– Income = profit = earnings– Profit before tax (PBT)– Profit after tax (PAT)– Earnings before tax (EBT)– Earnings after tax (Net Income)

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Earnings

Earnings– Also called net income– Paid out as dividends or retained in

business

Retained Earnings (RE)– Each year earnings not paid as dividends

become an addition to equity– Retained earnings account is cumulative

earnings not paid out as dividends

The Balance Sheet

Lists everything a company owns and owes at a moment in time– All sources and uses of money must be

equal

A firm’s money sources include creditors and owners– Borrowing creates a liability for repayment

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The Balance Sheet

Two equal sidesAssets = liabilities + equity

Assets and liabilities are arranged in order of decreasing liquidityLiquidity – ease with which an asset becomes

or a liability requires cash

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Table 2-2 A Conventional Balance Sheet Format

Assets

Cash

Checking balances plus currency

Marketable securities are liquid investments held instead of cash– Short-term, modest

return, low risk

Accounts Receivable

Uncollected credit sales– Bad Debt Reserve:

some credit sales will never be paid

– Write Off: Remove bad debt from gross and reserve leaving net unchanged

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Concept Connection Example 2-1 Writing Off a Large Uncollectable Receivable

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Gross accounts receivable $5,650Bad-debt reserve (290)Net accounts receivable $5,360

Need to Write Off $435,000Reserve 290,000Expense $145,000Reestablish Reserve (5%) 260,750Profit Reduction $405,750

Assets

Inventory - product held for sale in the normal course of business– Work-In-Process Inventories (WIP)

Value added as inventory moves through production

– The Inventory ReserveSome inventory is unusable - balances reported net of reserve

– Writing Off Bad InventoryMissing, damaged, or obsolete items removed from gross and reserve leaving net unchanged

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Assets

Overstatements– If assets are overstated, firm’s value is less than

total shown on balance sheet

Current Assets– Become cash within a year– Include cash, accounts receivable and inventory

Fixed Assets– Long lived, depreciable, also called property, plant

and equipment (PPE)– Useful life of at least a year

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Assets

Depreciation– Spreads asset’s cost over its estimated

useful life

Financial Statement Representation– Appears as an expense or cost– Accumulated depreciation appears on

balance sheet reflecting a wearing out of the asset

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Table 2-3 Fixed Asset Depreciation

Assets

Disposing of a Used Asset

The Life Estimate

Tax Depreciation and Tax Books– Government allows different depreciation

schedules for tax purposes and financial reporting purposes

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Concept Connection Example 2-2 Selling a Fixed Asset

Accounting Cash Flow

Revenue $4,000 $4,000

Cost (NBV) 2,500

Profit contribution: EBT $1,500

Tax (30%) (450) (450)

Contribution: net income $1,050

Cash flow $3,550

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Liabilities

What a company owes to outsiders

Accounts Payable– Arise when a firm buys from vendors on credit

Terms of Sale– Specify when payment is due on credit sales

and the early payment discount

Understated Payables

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Liabilities

Accruals– Recognize expenses and liabilities

associated with incomplete transactions Payroll Accrual

Current Liabilities– Require cash within one year– Payable and accruals are classified as

current

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Figure 2-1 A Payroll Accrual

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Working Capital

Total current assets = gross working capital

Net Working Capital = Current Assets ─ Current Liabilities

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Long Term Liabilities

Long Term Debt– The most significant non-current liability– Leverage

A business partially financed with debt is leveraged

Fixed Financial Charges– Interest must be paid regardless of

profitability

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Concept Connection Example 2-3 Leverage

A business is financed with equity of $100,000

Net Income = $15,000

Return on equity = 15% ($15,000/$100,000)

Calculate return on equity if $50,000 borrowed at an after tax interest rate of 10%

Concept Connection Example 2-3Leverage

Borrowing levers return on equity up from 15% to 20%.

Equity

Common Stock

Preferred Stock– Has mix of characteristics of both debt and equity

Retained Earnings– All previous earnings not paid out as dividends

Capital– The sum of long-term debt and equity

Total Liabilities and Equity– Sum of the right-hand side of the balance sheet– Must equal total assets

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Equity Accounts Illustration

Three Separate Accounts

Direct Investment by owners paying for stock

Par value and paid in excess accounts

Retained Earnings

Illustration: 20,000 shares of $2 par sold for $8

Firm Earns $70,000

Pays dividends of $15,000

Common Stock ($2 x 20,000) $ 40,000

Paid in Excess ($6 x 20,000) 120,000

Retained Earnings ($70,000 - $15,000) 55,000

Total Equity $215,000

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Net Income and Retained Earnings

Beginning Equity

+ Net Income

– Dividends

+ New Stock Sold

= Ending Equity

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The Tax Environment

Taxing Authorities and Tax BasesIncome tax

Wealth tax

Consumption taxSales tax

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Income Taxes—The Total Effective Tax Rate (TETR)

Total effective tax rate (TETR) is the combined state and federal rate– State tax is deductible from income when

calculating federal tax

TETR = Tf + Ts (1 – Tf)

where

Tf = federal tax rate

Ts = state tax rate

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Progressive Tax Systems, Marginal and Average Rates

Progressive tax system

Brackets

Marginal and average tax rates

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Capital Gains and Losses

Two major types of income

– Ordinary income

– Capital gains or loss and dividends

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The Tax Treatment of Capital Gains and Losses

Capital gains historically taxed at lower rates

Holding period must be > 1 year for favorable tax treatment

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Income Tax Calculations

Income taxes are paid by households and corporations according to the same basic principles– Tax is levied on a base of taxable income

But rate schedules for corporations and households are very different as are the rules for calculating taxable income

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Table 2-4 Personal Tax Schedules - 2012

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Personal Taxes

Taxable Income– Wages, profits, interest and dividends are

basic taxable income– Deductions are personal expenditures that

can be subtracted from income before calculating taxes

– Exemptions are fixed amounts per person that can be subtracted from income to arrive at taxable income

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Concept Connection Example 2-4 Calculating Personal Taxes

The Harris family had the following income in 2012:

Salaries: Joe $55,000

Sue 52,000

Interest on savings acct 2,000

Interest on IBM bonds 800

Interest on Boston Bonds 1,200

Dividends - Gen Motors 600

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Concept Connection Example 2-4 Calculating Personal Taxes

In 2012 the Harris family:

Sold property for $50,000, paid $53,000 years earlier

Sold stock for $14,000, paid $12,000 years earlier.

Paid $12,000 interest on home mortgage

Paid $1,800 in real estate taxes.

Had $3,500 withheld from pay for state income tax

Contributed $1,200 to charity.

Have two children

Exemption rate is $3,800 per person.

Calculate taxable income and tax liability.

What are marginal and average tax rates?

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Concept Connection Example 2-4 Calculating Personal Taxes

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Ordinary income: Deductions: Salaries $107,000 Mortgage interest $12,000 Interest 2,800 Taxes

5,300 $109,800 Charity 1,200

$18,500

Net capital gain or loss: Loss on property ($3,000) Exemptions:

Gain on stock 2,000 $3,800 x 4 = $15,200Net capital loss ($1,000)

Total Income $108,800 Taxable Income $75,100

(excludes dividends)

Concept Connection Example 2-4 Calculating Personal Taxes

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Use the married filing jointly schedule as follows:

10% of the entire first bracket $17,400 x .10 = $1,74015% of the amount in the

second bracket ($70,700- $17,400) x .15 = 7,99525% of the amount in the

third bracket ($75,100 - $70,700) x .25 = 1,000 Tax Liability $10,835

Tax on dividends $600 x .15 = 90 Total tax liability $10,925

Average tax rate: $10,925/$75,700 = 14.4%Marginal tax rate = bracket rate = 25%

(15% if dividends or capital gains)

Personal Taxes

Tax Rates and Investment Decisions– Comparing municipal (muni) and corporate

bondsInterest on muni’s not subject to federal taxes

At same rate muni’s return is higher after taxes

If the rates differ, restate corporate to an after tax yield

Multiply by one minus investor’s marginal tax rate

(1 – marginal tax rate)

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Concept Connection Example 2-5 Comparing Taxable and Tax Exempt Returns

The Harris family (25% bracket) has a choice between an IBM bond paying 11% and a Boston bond paying 9%.

Solution:

IBM after tax = 11% x (1 - .25) = 8.25% < Boston = 9%

Therefore prefer the Boston bond if risks are similar.

If marginal tax rate is 15%

11% x (1 - .15) = 9.35%

then prefer IBM

High bracket taxpayers tend to be more interested in tax exempt bonds than those with lower incomes.

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Corporate Taxes

Similar in principle to personal taxes: total income is revenue

Earnings Before Tax (EBT) is taxable income

Corporate tax rates do not consistently rise as taxable income rises

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Table 2-5 Corporate Income Tax Schedule

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The rate increases from 34% to 39% and 35% to 38% recover the benefit of lower rates on earlier income. So a corporation earning more than $18,333,333 pays 35% on all of its income from the first dollar.

Concept Connection Example 2-6 Corporate Income Taxes

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Calculate the tax liability for corporations with the following EBTs:a. $280,000b. $500,000c. $16,000,000d. $23,000,000

SOLUTION:a. Applying the corporate tax table to $280,000 yields the following:

$ 50,000 × .15 = $ 7,500$ 25,000 × .25 = 6,250$ 25,000 × 34 = 8,500$180,000 × .39 = $ 70,200

$ 92,450

b. Between $335,000 and $10 million the overall tax rate is 34% so the tax on $500,000 is

$500,000 × 34 = $170; 000

Concept Connection Example 2-6 Corporate Income Taxes

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c. We don’t have to go through the calculations in the bottom brackets because we know that the system recovers those benefits to an overall 34% up to $10 million.

$10,000,000 × .34 = $3,400,000$ 5,000,000 × .35 = $1,750,000$ 1,000,000 × .38 = $ 380,000 $5,530,000

d. Over $18,333,333, the tax is a flat 35% of all income starting from nothing, so the tax on $23,000,000 is

$23,000,000 × .35 = $8,050,000

Corporate Taxes

Taxes and Financing– The tax system favors debt financing– Result: A debt-financed firm pays less tax

than an identical equity financed company – But the availability of debt is limited because

it makes the borrowing company risky

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Corporate Taxes

Corporate Taxes

Dividends Paid to Corporations– Dividends paid to another corporation are

partially tax exempt

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Figure 2-2 Multiple Taxation

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Figure 2-3 Tax Loss Carry Back and Forward

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