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

2. 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

3. 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

4. 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

5. The Nature of Financial Statements
Three Financial Statements
Income statement
Balance sheet
Statement of cash flows
Generated from the income statement and balance sheet

6. 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

7. Table 2-1 A Typical Income Statement

8. The Income Statement Sales Cost and Expenses Costs of Goods Sold
Depreciation
Gross margin
Earnings before interest and taxes (EBIT)

9. Earnings Before Tax, and Tax Net Income Terminology:
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)

10. Retained Earnings (RE)
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

11. Lists everything a company owns and owes at a moment in time
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

12. Assets and liabilities are arranged in order of decreasing liquidity
The Balance Sheet
Two equal sides
Assets = liabilities + equity
Assets and liabilities are arranged in order of decreasing liquidity
Liquidity – ease with which an asset becomes or a liability requires cash

13. Table 2-2 A Conventional Balance Sheet Format

14. 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

15. Concept Connection Example 2-1 Writing Off a Large Uncollectable Receivable
Gross accounts receivable $5,650 Bad-debt reserve (290) Net accounts receivable $5,360 Need to Write Off $435,000 Reserve 290,000 Expense $145,000 Reestablish Reserve (5%) 260,750 Profit Reduction $405,750

16. 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 Reserve
Some inventory is unusable - balances reported net of reserve
Writing Off Bad Inventory
Missing, damaged, or obsolete items removed from gross and reserve leaving net unchanged

17. 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

18. Financial Statement Representation
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

19. Table 2-3 Fixed Asset Depreciation

20. Disposing of a Used Asset The Life Estimate
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

21. Concept Connection Example 2-2 Selling a Fixed Asset
Accounting Cash Flow
Revenue $4,000 $4,000
Cost (NBV) ,500
Profit contribution: EBT $1,500
Tax (30%) (450) (450)
Contribution: net income $1,050
Cash flow $3,550

22. 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

23. Liabilities Accruals Current Liabilities
Recognize expenses and liabilities associated with incomplete transactions
Payroll Accrual
Current Liabilities
Require cash within one year
Payable and accruals are classified as current

24. Figure 2-1 A Payroll Accrual

25. Working Capital Total current assets = gross working capital
Net Working Capital = Current Assets ─ Current Liabilities

26. Fixed Financial Charges
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

27. 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%

28. Concept Connection Example 2-3 Leverage
Borrowing levers return on equity up from 15% to 20%.

29. Equity Common Stock Preferred Stock Retained Earnings Capital
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

30. 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) ,000
Retained Earnings ($70,000 - $15,000) ,000
Total Equity $215,000

31. Net Income and Retained Earnings
Beginning Equity
+ Net Income
– Dividends
+ New Stock Sold
= Ending Equity

32. Taxing Authorities and Tax Bases
The Tax Environment
Taxing Authorities and Tax Bases
Income tax
Wealth tax
Consumption tax
Sales tax

33. 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

34. Progressive Tax Systems, Marginal and Average Rates
Brackets
Marginal and average tax rates

35. Capital Gains and Losses
Two major types of income
Ordinary income
Capital gains or loss and dividends

36. 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

37. 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

38. Table 2-4 Personal Tax Schedules - 2012

39. 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

40. Concept Connection Example 2-4 Calculating Personal Taxes
The Harris family had the following income in 2012:
Salaries: Joe $55,000
Sue ,000
Interest on savings acct ,000
Interest on IBM bonds
Interest on Boston Bonds ,200
Dividends - Gen Motors

41. 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?

42. Concept Connection Example 2-4 Calculating Personal Taxes
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 = $15,200 Net capital loss ($1,000) Total Income $108,800 Taxable Income $75,100 (excludes dividends)

43. Concept Connection Example 2-4 Calculating Personal Taxes
Use the married filing jointly schedule as follows: 10% of the entire first bracket $17,400 x .10 = $1,740 15% of the amount in the second bracket ($70,700- $17,400) x .15 = 7,995 25% 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)

44. Tax Rates and Investment Decisions
Personal Taxes
Tax Rates and Investment Decisions
Comparing municipal (muni) and corporate bonds
Interest 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)

45. 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 ( ) = 8.25% < Boston = 9%
Therefore prefer the Boston bond if risks are similar.
If marginal tax rate is 15%
11% x ( ) = 9.35%
then prefer IBM
High bracket taxpayers tend to be more interested in tax exempt bonds than those with lower incomes.

46. 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

47. Table 2-5 Corporate Income Tax Schedule
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.

48. Concept Connection Example 2-6 Corporate Income Taxes
Calculate the tax liability for corporations with the following EBTs:
a. $280,000
b. $500,000
c. $16,000,000
d. $23,000,000
SOLUTION:
a. Applying the corporate tax table to $280,000 yields the following:
$ 50,000 × .15 = $ 7,500
$ 25,000 × .25 = ,250
$ 25,000 × 34 = ,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

49. Concept Connection Example 2-6 Corporate Income Taxes
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

50. 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

51. Corporate Taxes

52. Dividends Paid to Corporations
Corporate Taxes
Dividends Paid to Corporations
Dividends paid to another corporation are partially tax exempt

53. Figure 2-2 Multiple Taxation

54. Figure 2-3 Tax Loss Carry Back and Forward