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

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The nature of financial statements
The Nature of Financial Statements Financial Statements and Taxes

  • 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


Accounts receivable
Accounts Receivable Financial Statements and Taxes

  • 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
Depreciation Financial Statements and Taxes

  • 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 statements1
The Nature of Financial Statements Financial Statements and Taxes

  • Three Financial Statements

    • Income statement

    • Balance sheet

    • Statement of cash flows

      • Generated from the income statement and balance sheet


The accounting system
The Accounting System Financial Statements and Taxes

  • 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


Table 2 1 a typical income statement
Table 2-1 A Typical Income Statement Financial Statements and Taxes


The income statement
The Income Statement Financial Statements and Taxes

  • Sales

  • Cost and Expenses

    • Costs of Goods Sold

    • Expense

    • Depreciation

  • Gross margin

  • Earnings before interest and taxes (EBIT)


The income statement1
The Income Statement Financial Statements and Taxes

  • 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)


Earnings
Earnings Financial Statements and Taxes

  • 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
The Balance Sheet Financial Statements and Taxes

  • 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


The balance sheet1
The Balance Sheet Financial Statements and Taxes

  • 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


Table 2-2 A Conventional Financial Statements and TaxesBalance Sheet Format


Assets
Assets Financial Statements and Taxes

  • 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


Concept connection example 2 1 writing off a large uncollectable receivable
Concept Connection Example 2-1 Financial Statements and TaxesWriting 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


Assets1
Assets Financial Statements and Taxes

  • 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


Assets2
Assets Financial Statements and Taxes

  • 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


Assets3
Assets Financial Statements and Taxes

  • 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


Table 2-3 Fixed Asset Depreciation Financial Statements and Taxes


Assets4
Assets Financial Statements and Taxes

  • 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


Concept connection example 2 2 selling a fixed asset
Concept Connection Example 2-2 Selling a Fixed Asset Financial Statements and Taxes

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


Liabilities
Liabilities Financial Statements and Taxes

  • 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


Liabilities1
Liabilities Financial Statements and Taxes

  • 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


Figure 2 1 a payroll accrual
Figure 2-1 A Payroll Accrual Financial Statements and Taxes


Working capital
Working Capital Financial Statements and Taxes

Total current assets = gross working capital

Net Working Capital = Current Assets ─ Current Liabilities


Long term liabilities
Long Term Liabilities Financial Statements and Taxes

  • 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


Concept connection example 2 3 leverage
Concept Connection Example 2-3 Financial Statements and Taxes 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 3 leverage1
Concept Connection Example 2-3 Financial Statements and TaxesLeverage

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


Equity
Equity Financial Statements and Taxes

  • 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


Equity accounts illustration
Equity Accounts Illustration Financial Statements and Taxes

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


Net income and retained earnings
Net Income and Retained Earnings Financial Statements and Taxes

Beginning Equity

+ Net Income

– Dividends

+ New Stock Sold

= Ending Equity


The tax environment
The Tax Environment Financial Statements and Taxes

Taxing Authorities and Tax Bases

  • Income tax

  • Wealth tax

  • Consumption tax

    • Sales tax


Income taxes the total effective tax rate tetr
Income Taxes—The Total Effective Tax Rate (TETR) Financial Statements and Taxes

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


Progressive tax systems marginal and average rates
Progressive Tax Systems, Marginal and Average Rates Financial Statements and Taxes

  • Progressive tax system

  • Brackets

  • Marginal and average tax rates


Capital gains and losses
Capital Gains and Losses Financial Statements and Taxes

  • Two major types of income

    • Ordinary income

    • Capital gains or loss and dividends


The tax treatment of capital gains and losses
The Tax Treatment of Capital Gains Financial Statements and Taxesand Losses

  • Capital gains historically taxed at lower rates

  • Holding period must be > 1 year for favorable tax treatment


Income tax calculations
Income Tax Calculations Financial Statements and Taxes

  • 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


Table 2 4 personal tax schedules 2012
Table 2-4 Personal Tax Schedules - 2012 Financial Statements and Taxes


Personal taxes
Personal Taxes Financial Statements and 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


Concept connection example 2 4 calculating personal taxes
Concept Connection Example 2-4 Financial Statements and TaxesCalculating 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


Concept connection example 2 4 calculating personal taxes1
Concept Connection Example 2-4 Financial Statements and TaxesCalculating 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?


Concept connection example 2 4 calculating personal taxes2
Concept Connection Example 2-4 Calculating Personal Taxes Financial Statements and Taxes

Ordinary income: Deductions:

Salaries $107,000 Mortgage interest $12,000

Interest 2,800 Taxes5,300

$109,800 Charity1,200

$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)


Concept connection example 2 4 calculating personal taxes3
Concept Connection Example 2-4 Financial Statements and TaxesCalculating 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)


Personal taxes1
Personal Taxes Financial Statements and 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)


Concept connection example 2 5 comparing taxable and tax exempt returns
Concept Connection Example 2-5 Financial Statements and TaxesComparing 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.


Corporate taxes
Corporate Taxes Financial Statements and 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


Table 2 5 corporate income tax schedule
Table 2-5 Corporate Income Tax Schedule Financial Statements and Taxes

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


Concept connection example 2 6 corporate income taxes
Concept Connection Example 2-6 Financial Statements and TaxesCorporate 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 = 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 taxes1
Concept Connection Example 2-6 Corporate Income Taxes Financial Statements and 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


Corporate taxes1
Corporate Taxes Financial Statements and 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


Corporate Taxes Financial Statements and Taxes


Corporate taxes2
Corporate Taxes Financial Statements and Taxes

  • Dividends Paid to Corporations

    • Dividends paid to another corporation are partially tax exempt


Figure 2 2 multiple taxation
Figure 2-2 Multiple Taxation Financial Statements and Taxes


Figure 2 3 tax loss carry back and forward
Figure 2-3 Tax Loss Carry Back and Forward Financial Statements and Taxes


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