slide1
Download
Skip this Video
Download Presentation
Chapter 2 - Financial background: A Review of Accounting, Financial Statements and Taxes

Loading in 2 Seconds...

play fullscreen
1 / 54

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


  • 84 Views
  • Uploaded on

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

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about ' Chapter 2 - Financial background: A Review of Accounting, Financial Statements and Taxes' - kamin


An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
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
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

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
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
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
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
corporate taxes2
Corporate Taxes
  • Dividends Paid to Corporations
    • Dividends paid to another corporation are partially tax exempt
ad