INTRODUCTION TO CORPORATE FINANCE SECOND EDITION Lawrence Booth & W. Sean Cleary Prepared by Ken Hartviksen & Jared Laneus

Chapter 3 Financial Statements 3.1 Accounting Principles 3.2 Organizing a Firm’s Transactions 3.3 Preparing Accounting Statements 3.4 Tim Horton’s Inc. Accounting Statements 3.5 The Canadian Tax System 2 Booth/Cleary Introduction to Corporate Finance, Second Edition

Learning Objectives 3.1 Describe what generally accepted accounting principles are and their significance and implications for a firm. 3.2 Organize a firm’s transactions, and explain what are the most important accounting principles related to this task. 3.3 Prepare a firm’s financial statements. 3.4 Analyze a firm’s financial statements. 3.5 Describe the Canadian tax system and explain the differences between how a corporation and an individual are taxed. 3 Booth/Cleary Introduction to Corporate Finance, Second Edition

Accounting Principles Accounting is an organized way of summarizing the activities of business. Internal and external users of accounting information rely on it to make decisions. Financial managers require a strong understanding of accounting because they use that information to make significant decisions that will affect the firm. Generally Accepted Accounting Principles (GAAP) are contained in the CICA Handbook and have the force of law in Canada The Income Tax Act (ITA) requires the use of the CICA Handbook, except where specifically the Act requires other treatment. This has led to the practice of Canadian firms reporting to shareholders using CICA GAAP and preparing separate financial statements for CRA. Reporting of financial performance in a consistent manner over time and between firms enhances the usefulness of those reports, allowing comparative analysis. 4 Booth/Cleary Introduction to Corporate Finance, Second Edition

International Convergence Different countries have different accounting standards set by professional organizations that regulate the profession: Canada: CICA, the Canadian Institute of Chartered Accountants USA: FASB, Financial Accounting Standards Board Japan: ASBJ, Accounting Standards Board of Japan Given the growing importance of international trade and the integration of product and financial markets, there is a need for countries to move to a common set of accounting standards. The London-based International Accounting Standards Board (IASB) has been working to achieve a common standard. 5 Booth/Cleary Introduction to Corporate Finance, Second Edition

Impact of Recent Accounting Scandals The Enron bankruptcy, in addition to other scandals involving WorldCom, Tyco. and others demonstrate the need for reform. Since investors use accounting information to make investing decisions and value firms, recent accounting scandals where financial statements were misleading have caused investors to lose confidence in financial markets. The U.S. Congress passed the Sarbanes-Oxley Act (SOX) in 2002 in an attempt to restore investor confidence by imposing new requirements for financial disclosure and oversight. 6 Booth/Cleary Introduction to Corporate Finance, Second Edition

Main Provisions of Sarbanes-Oxley (2002) A new Public Company Accounting Oversight Board Register and inspect public accounting firms Establish audit standards Separation of the audit function from other services provided by auditing firms Improved standards for corporate governance Separate board committees for finance and audit Require external auditors to report to the audit committee Require audit committee independence and financial expertise, with membership dominated by external directors New requirement that annual reports indicate the state of a firm’s internal controls and assess their effectiveness The CEO and CFO must certify that the firms financial statements “fairly present in all material respects the operations and financial condition of the issuer” 7 Booth/Cleary Introduction to Corporate Finance, Second Edition

Organizing a Firm’s Transactions Bookkeeping is the mechanical act of managing and recording transactions Accounting is the application of generally accepted accounting principles (GAAP) and conventions to bookkeeping data to produce financial statements that fairly represent the financial condition and operations of the economic entity The most basic principles of Canadian GAAP are: 1.The Entity Concept – accounting is for a specific economic entity 2.The Going Concern Principle – the statements are prepared on the basis that the economic entity will continue to operate into the future; therefore, liquidation values are irrelevant 3.A Period of Analysis – usually a fiscal year, although quarterly and monthly financial statements are also produced 8 Booth/Cleary Introduction to Corporate Finance, Second Edition

Organizing a Firm’s Transactions Basic principles of Canadian GAAP continued 4.A Monetary Value – historical costs are traditionally used because of the objectivity inherent in arms-length transactions 5.The Matching Principle – expenses incurred must be matched to the revenue earned in the period of analysis 6.Revenue Recognition – revenue is recognized when it has been earned, even though the cash may not yet have been received 9 Booth/Cleary Introduction to Corporate Finance, Second Edition

Organizing a Firm’s Transactions The major conventions of Canadian GAAP are: 1.Procedures – the debit and credit convention 2.Standards – CICA Handbook 3.Consistency – accounting principles should be applied consistently over time to ensure that the comparison of financial statements from different periods illustrates economic differences not just policy differences 4.Materiality – all significant information is disclosed 5.Disclosure – the firm’s financial condition is fully and fairly disclosed; objectivity, consistency and conformity to GAAP are all aspects of full disclosure 10 Booth/Cleary Introduction to Corporate Finance, Second Edition

Preparing Accounting Statements: The Balance Sheet The balance sheet is a financial snapshot at one point in time and is usually dated for the last day of the firm’s fiscal year It shows what the firm owns (assets) and how those assets were financed (liabilities and owners’ equity) Assets (debit accounts) are usually shown on the left side with liabilities and equity (credit accounts) on the right side Items are listed vertically in order of liquidity (e.g., cash is the first asset, while fixed assets like machinery are the last) 11 Booth/Cleary Introduction to Corporate Finance, Second Edition

Preparing Accounting Statements: The Income Statement The income statement is also known as the profit and loss statement Reports the income earned over a given period of time, usually a year, quarter or month. Applies the matching principle by reporting expenses incurred in order to earn the revenue recognized in that period Revenue is always reported on the top line, with expenses below Expenses are often reported separately by type: variable/direct, indirect/fixed, interest, amortization, income taxes, etc. 12 Booth/Cleary Introduction to Corporate Finance, Second Edition

Preparing Accounting Statements: Changing Accounting Assumptions GAAP provides flexibility in the accounting treatment of economic events, such as: When to recognize revenue When to capitalize an expense (as an asset) What rate to use for depreciation The compensation that managers receive is often tied to a company’s financial performance and managers often face considerable pressure to make the firm’s financial performance appear as good as possible. As a result of this pressure, management may change accounting policies within the limits allowed by GAAP to suit their needs and the current circumstances facing the firm Any change in the application of GAAP must be disclosed in the audited financial statements and could jeopardize the audit opinion offered by the external auditors if it is not in compliance with GAAP. 13 Booth/Cleary Introduction to Corporate Finance, Second Edition

Preparing Accounting Statements: Tax Statements In Canada, firms must report to Canada Revenue Agency (CRA) and remit income taxes in accordance with the Income Tax Act (ITA). CRA requires businesses to use capital cost allowance (CCA) rates for asset depreciation which are specified in the ITA’s Regulations. Firms in Canada tend to produce two sets of financial statements: one for shareholders prepared in accordance with GAAP, and another for the CRA prepared according to tax rules. Because capital cost allowance (CCA) is an accelerated method of amortization and assets are often replaced more frequently than they are fully depreciated: Actual income tax liabilities based on the ITA and CCA is usually less than what is “estimated” when reporting to shareholders under GAAP This creates an “intertemporal” differences in tax liability called deferred taxes which is capitalized on balance sheets when reporting to shareholders Therefore, deferred taxes does not mean the firm has an unpaid tax liability; it means there is an intertemporal difference in tax liability 14 Booth/Cleary Introduction to Corporate Finance, Second Edition

Accounting Income, Taxable Income and Economic Income Accounting income is the net profit of the firm obtained using GAAP and accounting depreciation Taxable income, or income for tax purposes is the net profit of the firm arrived at using GAAP and CCA in accordance with the Income Tax Act Economic income is the amount of funds a firm could withdraw from the firm at the end of an accounting period, and leave the firm in the same income earning position as it started the period Generally: Accounting Income > Taxable Income > Economic Income Accounting income is usually greater than income for tax because the CCA deductions are usually greater than accounting depreciation Economic income is less than income for tax because CCA and accounting depreciation amounts are based on historical cost which understates the amount of earnings a firm must retain since the firm will have to replace its asset base at higher replacement costs. 15 Booth/Cleary Introduction to Corporate Finance, Second Edition

Preparing Accounting Statements: Cash Flow Statements Accounting profit may not reflect the firm’s actual cash flow The cash flow statement helps to provide a clearer picture of sources and uses of cash Analysts are very interested in cash flow because it indicates a firm’s solvency Two methods to prepare a cash flow statement: 1.Examine the changes in the balance sheet accounts and reconcile them through the cash account 2.Add non-cash items to net income SOURCES OF CASHUSES OF CASH Asset DecreasesAsset Increases Liability IncreasesLiability Decreases Common Stock Increases Retained Earnings Increases 16 Booth/Cleary Introduction to Corporate Finance, Second Edition

Preparing Accounting Statements: Cash Flow Statements 17 Booth/Cleary Introduction to Corporate Finance, Second Edition

Tim Hortons’ Accounting Statements: Consolidated Statement of Cash Flows 18 Booth/Cleary Introduction to Corporate Finance, Second Edition

Tim Hortons’ Accounting Statements: Consolidated Balance Sheet 19 Booth/Cleary Introduction to Corporate Finance, Second Edition

Tim Hortons’ Accounting Statements: Consolidated Income Statement 20 Booth/Cleary Introduction to Corporate Finance, Second Edition

The Canadian Tax System Federal and provincial governments in Canada tax individuals and corporations based on income earned Corporations pay income taxes and then use after-tax income to distribute dividends to shareholders Dividends received by shareholders are taxed again as one form of personal investment income In recognition of this double-taxation of dividends, dividends from Canadian corporations are given some partial relief through the “dividend gross-up tax credit” Dividends received from non-Canadian companies do not qualify for this special tax treatment 21 Booth/Cleary Introduction to Corporate Finance, Second Edition

Corporate Income Taxation Corporate tax is paid at a flat or fixed rate on taxable income Small businesses are defined as those which earn income of $300,000 or less, and usually pay a lower rate of tax (depending on the province) Companies are free to choose their own taxation (fiscal) year but, once established, cannot alter it without justification and approval Taxable income generally is income earned during the fiscal year less expenses incurred in order to earn that income The income statement shows that variable costs and period overhead costs can be subtracted to determine earnings before interest and taxes (EBIT) For tax purposes the Income Tax Act requires that the capital cost allowance system be used instead of accounting amortization Interest expenses on debt borrowed to earn income is generally deductible from taxable income 22 Booth/Cleary Introduction to Corporate Finance, Second Edition

Capital Cost Allowance Capital cost allowance (CCA) is the method of depreciation or amortization used by taxpayers in Canada when reporting business income to CRA for tax purposes Since CCA affects a firm’s net income and its net cash flow, taxation issues must be addressed in each financial decision a firm makes and decision makers need to understand CCA CCA gives rise to a tax-shield benefit CCA is a non-cash deduction from income that would otherwise be subject to income tax. Taxable income is reduced as a result of the deduction and the result is a savings in tax payable Tax shield benefit = corporate tax rate × dollar amount of claimed CCA Example: A firm with a 40% corporate tax rate and a $2,000 CCA deduction will save $800 in taxes Because of the half-year rule, only one-half of the CCA rate can be applied to net acquisitions to an asset class in the year the assets are acquired; so the first year’s CCA is less than the second year’s CCA 23 Booth/Cleary Introduction to Corporate Finance, Second Edition

CCA versus Accounting Depreciation Capital Cost Allowance Similar assets are grouped into pools or classes Each asset class’s CCA rate is specified in the Regulations to the ITA and approximates the economic wastage of the asset No estimate of useful life or salvage value is necessary As long as the firm remains a going concern and assets remain in the pool, residual undepreciated capital cost (UCC) values remain in the pool Accounting Depreciation Firms choose the method that best represents the economic wastage of the asset Assets are depreciated individually, not in a group Estimates of useful life and salvage value are necessary 24 Booth/Cleary Introduction to Corporate Finance, Second Edition

CCA Over Time CCA is like a declining balance method and changes each year The largest benefit occurs in the early years of an asset’s life Residual values always remain in the pool, even after the asset is disposed 25 Booth/Cleary Introduction to Corporate Finance, Second Edition

CCA, Capital Gains, Recapture and Terminal Loss A taxable capital gain would occur if the firm sold a depreciable asset for greater than its original cost Capital Gain = Original Cost Base – Salvage Value Recapture of Depreciation: if the salvage value of the asset exceeds the undepreciated capital cost (UCC) of the asset pool, there is a recapture of depreciation which is subject to tax An asset pool is closed when the last physical asset in the pool is sold and not replaced Terminal Loss: if there is a positive UCC balance remaining in the pool when it closes, that balance is called a terminal loss and is deductible from taxable income in the year the last asset is disposed; terminal losses are non-cash deductions just like CCA 26 Booth/Cleary Introduction to Corporate Finance, Second Edition

Personal Income Taxation Canadians are taxed on their worldwide income The taxation year is the calendar year: January 1 st to December 31 st The personal tax system is progressive in most provinces, where tax rates increase as the amount of a person’s income increases Investment income can be earned by investors in one of three different forms, each of which is taxed differently: Interest Dividends Capital Gains 27 Booth/Cleary Introduction to Corporate Finance, Second Edition

Personal Income Taxation of Interest Interest income is taxed at the person’s marginal personal tax rate, which is the same rate at which employment and business income is taxed Marginal personal tax rates depend on the amount of income earned in a progressive tax system All sources of interest must be claimed in each calendar year, both cash interest payments received and interest that has accrued but not yet been paid (e.g., Canada Savings Bonds that have not yet been redeemed) The marginal tax rates on interest income are usually (depending on a person’s circumstances) higher than those on dividends and capital gains 28 Booth/Cleary Introduction to Corporate Finance, Second Edition

Personal Income Taxation of Dividends Dividends from Canadian companies receive a special tax treatment called the “gross-up tax credit” Cash dividends from eligible corporations are grossed up by 45% and this total amount is included in taxable income Federal and provincial tax credits, which vary from province to province, are deducted from the grossed up amount Federal tax credit: 18.97% Provincial tax credits vary from a low 14.55% in Alberta to a high of 29.69% in Quebec The tax credits reduce the marginal tax rate applied to dividend income 29 Booth/Cleary Introduction to Corporate Finance, Second Edition

Personal Income Taxation of Capital Gains Only realized capital gains are taxed which means that unrealized capital gains do not trigger tax until investments are sold. Investors can therefore defer capital gains taxes until funds are required. Only one-half (50%) of a realized capital gain is subject to tax at the person’s marginal tax rate Capital losses can be used to offset taxable capital gains At higher marginal tax rates, investors prefer to receive investment income in the form of capital gains and dividends because these are often taxed at a lower marginal rate than interest income 30 Booth/Cleary Introduction to Corporate Finance, Second Edition

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