- 1. Financial Background:A Review of Accounting, Financial
Statements,and Taxes
2. The Nature of Financial Statements
- Three Financial Statements
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- Generated from the incomestatement and balancesheet
2 3. The Accounting System
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- In double entry accounting every entry has two sides that must
balance
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- Example:Borrowing $1,000 to buy a machine, involves
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- increasing an asset account by $1,000
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- increasing a liability account by $1,000
3 4. The Accounting System
- Accounting Periods and Closing the Books
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- Books are closed by updating the periods transactions in the
accounting system and creating financial statements
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- Last periods statements dont say anything about what WILL
happen next year
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- Can be used to make predictions
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- Income statement reflects money flows over a period of
time
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- Balance sheet represents stocks of money at a point in
time
4 5. A Typical Income Statement
- Earnings bef. interest & tax $170
5 6. The Income Statement
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- Total receipts from selling goodsfrom normal business
operations
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- Represent money spent to do business
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- Costs of Goods Sold money spent on itemsclosely related to the
production of theproduct or service being sold
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- Expense spending on items that arent closelyrelated to
production (such as marketing)
6 7. The Income Statement
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- Represents sales revenue less cost of goods sold
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- Fundamental measure of profitability
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- Price the firm pays for borrowing money
- Earnings Before Interest and Taxes (EBIT)
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- Profit before considering financing charges
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- Also called operating profit
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- Helps judge the strength of business operations without
onsidering the interest expense a firm with debt pays
7 8. The Income Statement
- Earnings Before Tax (EBT) and Tax
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- Earnings before taxes (EBT) represent gross margin less all
expenses except taxes
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- Tax refers to income taxes on EBT
- Net Income (also Earnings After Tax or EAT)
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- Represents the bottom linecalculated by subtracting tax from
EBT
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- Belongs to the companys owners and can be paid out as dividends
or retained
8 9. The Balance Sheet
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- Assets = liabilities + equity
- Also called aStatement of Financial Position
- Assets and liabilities arearranged in order of decreasing
liquidity
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- Liquidity ease with which an asset becomes cash
9 10. 10 A Conventional Balance Sheet Format 11. Assets
- Money in checking accounts plus currency on hand
- Marketable securities are liquid investments held instead of
cash
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- Short-term, modestreturn, low risk
- Represent credit sales that have not yet been paid
- Bad Debt Reserve :some credit sales will never be paid
- Write Off : When a receivable isuncollectible, it is taken out
of the balance. A like amount is subtracted from the bad debt
reserve leaving the net unchanged
11 12. Assets
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- Product held for sale in the normalcourse of business
- Work-In-Process Inventories
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- As inventory moves through the production process, value is
added increasing the balance
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- Some inventory is usually unusable - inventory balances are
reported net of a reserve
- Writing Off Bad Inventory
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- Missing, damaged, or obsolete items are removed and a like
subtraction made from the reserve
12 13. Assets
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- If assets (usually receivables and inventory) are overstated
firms value is less than the amountshown on the balance sheet
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- Can mean a firm is not managed efficiently
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- Become cash within one year
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- Include cash, accounts receivable andinventory
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- Money received from normal business operations flows through
these accounts
13 14. Assets
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- Long lived not physically fixed
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- Sometimes called property, plant and equipment (PPE)
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- Useful life of at least a year
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- Spreads assets cost over its estimated useful life
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- Matching principle an assets cost should be recognized over a
period matching its service life
- Financial Statement Representation
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- Depreciation on the income statement reflects an assets cost,
the same depreciation also appears on the balance sheet reflecting
a wearing out
14 15. Assets
- Disposing of a Used Asset
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- An asset may be sold for more or less than the net asset value
on the books
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- An asset remaining in use beyond its depreciation life is fully
depreciated
- Tax Depreciation and Tax Books
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- Government allows different depreciation schedules for tax
purposes and financial reporting purposes
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- Tax books financial records generated using tax rules
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- Financial books regular financial statements
15 16. Liabilities
- What a companyowes to outsiders
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- Arise when a firm buys from vendors on credit
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- Trade Credit vendor delivers product withoutdemanding immediate
payment
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- Specify when payment is due on credit
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- sales and the early payment discount
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- 2/10, n/30 -payment in 30 days with a2% discount if paid within
10 days
16 17. Liabilities
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- Represent incomplete transactions
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- Recognizes expenses and liabilities associated with incomplete
transactions
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- Common example is a Payroll Accrual
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- Require cash within one year
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- Includes payables, accruals, notes payable, short-term loans,
long-term debt due within the year
17 18. Working Capital
- Total current assets aregross working capital required to run a
business day to day
- Net working capital is the difference between current assets
and current liabilities
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- Cant run a business without it
18 19. Liabilities
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- The most significant non-current liability
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- Consists of bonds and long-term loans
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- A business partially financed with debt is leveraged
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- In good times leverage enhances return on investment
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- But in bad times it makes return on investment worse
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- The most significant concern about borrowed money is fixed
interest charges
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- Interest Must be paid regardless of profitability
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- Can lead to bankruptcy in bad times
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- I.e., too much debt can cause business failure
19 20. 20 Leverage 21. Equity
- Funds supplied to a business by owners
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- Direct investment price paid for stock or entrepreneurs
contribution
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- Retained earnings profits kept in the business rather than paid
to owners
- Balance sheet Representation of Equity
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- Common stock accountcarries a par value per share
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- Par is an arbitrary number
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- Excess or surplusrepresents amounts paid for the stock in
excess of (over) par value
21 22. Equity
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- Profits that have not beendistributedto owners
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- As dividends if firm is a corporation
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- Do not represent a reserve of cash
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- Adds up all the earnings ever retained by the firm
22 23. Example: Equity Accounts
- A firm is started by selling 20,000 shares of $2 par value
stock at $8 per share.Subsequently the company earns $70,000 out of
which it pays dividends of $15,000
- Common stock ($2 x 20,000 =)$ 40,000
- Paid in excess ($6 x 20,000=) 120,000
- ($70,000 - $15,000 =)55,000
23 24. The Relationship Between Net Income and Retained
Earnings
- If no dividends are paid and no new stock is sold
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- Beginning equity + net income = ending equity
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- Beginning equity + net income dividends
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- Beginning equity + net income dividends + stock
24 25. Equity
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- Equity that has some of thecharacteristics of debt
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- Although a hybrid, it is classified as equity
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- The sum of long-term debt and equity
- Total Liabilities and Equity
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- Sum of the right-hand side of the balance sheet
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- Must always equal total assets
25 26. The Tax Environment
- Taxing Authorities and Tax Bases
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- Taxes are imposed by various government authorities
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- A tax base is the item that is taxed
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- Income, wealth or consumption
26 27. Taxing Authorities andTax Bases
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- Individuals pay a fraction ofincome in a certain timeperiod to
the taxing authority
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- Based on the value of certain types of assets, usually real
estate
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- Based on the amount of certain goods used, usually sales
taxes
27 28. Income TaxesThe Total Effective Tax Rate
- Total effective tax rate(TETR) is the combined rate to which
the taxpayer is subject
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- State tax is deductible from income whencalculating federal
tax
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- TETR = T federal tax rate+ T state tax rate (1 T federal tax
rate )
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- If a taxpayer is subject to a 30% federal tax rate and a 10%
state tax rate, the TETR is
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- Less than the sum of the two rates
28 29. Progressive Tax Systems, Marginal and Average Rates
- Progressive tax system- higher tax rateson incrementallyhigher
income
- Tax bracket- range of income inwhich the tax rate is
constant
- Marginal tax rate- rate paid on thenext dollar of income a
taxpayer earns
- Average tax rate- the percentage of total income paid in
taxes
29 30. Progressive Tax Systems, Marginal and Average Rates 30 Q:
Given the following tax brackets, calculate the tax on an income
of$11,000.Also calculate the taxpayers marginal and average rates.
A: Since the taxpayer earned more than $5,000 (but less than
$15,000) she will be taxed at two rates.The first $5,000 is taxed
at 10%: $5,000 x .10 = $500The remaining $6,000 is taxed at 15%
$6,000 x .15 =$900 Thus, her total tax is $1,400 Her marginal tax
rate is 15%, since she would pay that on her next dollar of
income,and her average tax rate is$1,400$11,000 = 12.7% Example 25%
Over $15,000 15% $5,000 - $15,000 10% 0 - $5,000 Tax Rate Bracket
31. Capital Gains and Losses
- Two major types of income
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- Ordinary income results fromnormal money-making activity
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- Wages, business profits, dividendsand interest
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- Negative profits are an ordinary loss
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- Capital gains or lossarises when something is purchased, held
for a while and sold at a different price
31 32. The Tax Treatment of Capital Gains and Losses
- Historically capital gains have beentaxed at lower rates than
ordinaryincome
- Ifholding period < 1 yearthen short-termcapital gain is not
eligible for favorabletax treatment
- Gains onassets held for > 1 yearqualifyfor long-term
treatment
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- Tax rate capped at 15% for individuals
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- Capital losses offset capital gains
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- Corporations do not receive favorable rates on capital
gains
32 33. Personal Taxes
- Taxes on people (households) are calledpersonal or individual
taxes
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- Separate schedules exist for single individuals, married
couples filing jointly, married people filing separately and
certain heads of household
- Between 2001 and 2003 Congress lowered personal tax rates to
stimulate the economy
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- Before 2001 the top rate was 39.6%
33 34. Personal Tax Schedules - 2006 Table 2.4 34 35. Personal
Taxes
- Tax Rates and Investment Decisions
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- When comparing municipal bond investments to corporate bonds,
an adjustment must be made
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- Interest on munis are not taxed
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- If a muni and corporate bond, of similar risk, are paying the
same rate, the munis return is higher after taxes
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- If the rates differ, the corporate bond must be adjusted toan
after tax yield by multiplying by
35 36. Example 2.2 - Comparing Corporate and Municipal Bonds
- The Smith family has the following choice
- State AT&T after tax at marginal rate
- If marginal rate is 15%, AT&T is better:
36 37. Corporate Taxes
- Similar in principle to personal taxes
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- Total income is business revenue
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- Deductions are the charges and expenditures required to run the
company
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- Exemptions are not allowed
- Earnings Before Tax (EBT) is taxable income
- Corporate tax rates do not consistently rise as taxable income
rises
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- With personal taxes taxpayers pay a lower rate on income in the
bottom brackets
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- Corporate tax tables are constructed so that firms with high
incomes pay a constant rate on all of their income
37 38. Corporate Income Tax Schedule Table 2.5 38 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.
39. Corporate Taxes Example 2.3 39 Q: Calculate, using the
corporate tax rates in Table 2.5, the tax liability for a
corporation making EBT of $280,000. A: Applying the corporate tax
table results in the following tax liability: Example $92,450 Total
$70,200 $180,000 x .39 $8,500 $25,000 x .34 $6,250 $25,000 x .25
$7,500 $50,000 x .15 40. Corporate Taxes
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- The tax systemfavors debtover equity financing
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- Interest payments made to debt investors are tax deductible to
the paying company
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- Dividend payments to equity investors are not deductible
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- Result : A debt financed firm pays less tax than an otherwise
identical equity financed company
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- But the availability ofdebt is limitedbecause it makes the
borrowing company risky
40 41. Taxes and Financing 41 42. Corporate Taxes
- Dividends Paid to Corporations
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- Dividends paid to another corporation are partially tax
exempt
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- The percentage exempted depends on the amount of stock owned by
the company
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- Avoids more than double taxation of corporate earnings
42 43. Corporate Taxes
- Tax Loss Carry Back and Carry Forward
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- Business losses can be carried backward or forward in time to
offset taxes that might otherwise be excessive
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