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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Chapter 2 financial background a review of accounting financial statements and taxes

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


The nature of financial statements

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


Accounts receivable

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

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 statements1

The Nature of Financial Statements

  • 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

  • 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


The income statement

The Income Statement

  • Sales

  • Cost and Expenses

    • Costs of Goods Sold

    • Expense

    • Depreciation

  • Gross margin

  • Earnings before interest and taxes (EBIT)


The income statement1

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)


Earnings

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

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


The balance sheet1

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


Chapter 2 financial background a review of accounting financial statements and taxes

Table 2-2 A Conventional Balance Sheet Format


Assets

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


Concept connection example 2 1 writing off a large uncollectable receivable

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


Assets1

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


Assets2

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


Assets3

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


Chapter 2 financial background a review of accounting financial statements and taxes

Table 2-3 Fixed Asset Depreciation


Assets4

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


Concept connection example 2 2 selling a fixed asset

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


Liabilities

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


Liabilities1

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


Figure 2 1 a payroll accrual

Figure 2-1 A Payroll Accrual


Working capital

Working Capital

Total current assets = gross working capital

Net Working Capital = Current Assets ─ Current Liabilities


Long term liabilities

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


Concept connection example 2 3 leverage

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 3 leverage1

Concept Connection Example 2-3Leverage

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


Equity

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


Equity accounts illustration

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


Net income and retained earnings

Net Income and Retained Earnings

Beginning Equity

+ Net Income

– Dividends

+ New Stock Sold

= Ending Equity


The tax environment

The Tax Environment

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)

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

  • Progressive tax system

  • Brackets

  • Marginal and average tax rates


Capital gains and losses

Capital Gains and Losses

  • 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 and Losses

  • Capital gains historically taxed at lower rates

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


Income tax calculations

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


Table 2 4 personal tax schedules 2012

Table 2-4 Personal Tax Schedules - 2012


Personal taxes

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


Concept connection example 2 4 calculating personal taxes

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


Concept connection example 2 4 calculating personal taxes1

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?


Concept connection example 2 4 calculating personal taxes2

Concept Connection Example 2-4 Calculating Personal 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 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)


Personal taxes1

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)


Concept connection example 2 5 comparing taxable and tax exempt returns

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.


Corporate taxes

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


Table 2 5 corporate income tax schedule

Table 2-5 Corporate Income Tax Schedule

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 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 = 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

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

  • 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


Chapter 2 financial background a review of accounting financial statements and taxes

Corporate Taxes


Corporate taxes2

Corporate Taxes

  • Dividends Paid to Corporations

    • Dividends paid to another corporation are partially tax exempt


Figure 2 2 multiple taxation

Figure 2-2 Multiple Taxation


Figure 2 3 tax loss carry back and forward

Figure 2-3 Tax Loss Carry Back and Forward


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