Chapter 2 - Financial background: A Review of

Accounting, Financial Statements and Taxes

The Nature of Financial Statements

Numerical representations of a firms

activities for an accounting period
A picture of activities within the firm and
between the firm and the outside
But can be counterintuitive

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 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

Proration of an assets 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 Statements

Three Financial Statements

Income statement
Balance sheet
Statement of cash flows
Generated from the income statement and
balance sheet

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 The Accounting System

A firms 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

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Table 2-1 A Typical Income Statement

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 The Income Statement

Sales
Cost and Expenses
Costs of Goods Sold
Expense
Depreciation
Gross margin
Earnings before interest and taxes (EBIT)

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 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)

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 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

Lists everything a company owns and

owes at a moment in time
All sources and uses of money must be
equal
A firms money sources include creditors
and owners
Borrowing creates a liability for repayment

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 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

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Table 2-2 A Conventional
Balance Sheet Format

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 Assets

Cash Accounts Receivable

Checking balances Uncollected credit sales
plus currency Bad Debt Reserve:
Marketable securities some credit sales will
are liquid investments never be paid
held instead of cash Write Off: Remove bad
Short-term, modest debt from gross and
return, low risk reserve leaving net
unchanged

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 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

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 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

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 Assets

Overstatements
If assets are overstated, firms 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

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 Assets

Depreciation
Spreads assets 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

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Table 2-3 Fixed Asset Depreciation

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 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

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 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

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 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

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 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

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Figure 2-1 A Payroll Accrual

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 Working Capital

Total current assets = gross working capital

Net Working Capital = Current Assets Current Liabilities

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

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 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

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Net Income and Retained Earnings

Beginning Equity
+ Net Income
Dividends
+ New Stock Sold
= Ending Equity

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 The Tax Environment

Taxing Authorities and Tax Bases

Income tax
Wealth tax
Consumption tax
Sales tax

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Income TaxesThe 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

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

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 Capital Gains and Losses

Two major types of income

Ordinary income

Capital gains or loss and dividends

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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

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 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

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Table 2-4 Personal Tax Schedules - 2012

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 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

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 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

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 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?

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 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)

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 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
25% of the amount in the
third bracket
Tax on dividends $600 x .15 =
($70,700- $17,400) x .15 = 7,995
($75,100 - $70,700) x .25 = 1,000
Tax Liability $10,835
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)

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 Personal Taxes

Tax Rates and Investment Decisions

Comparing municipal (muni) and corporate
bonds
Interest on munis not subject to federal taxes
At same rate munis return is higher after taxes
If the rates differ, restate corporate to an after tax
yield
Multiply by one minus investors marginal tax rate
(1 marginal tax rate)

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 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.

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 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
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 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.

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 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

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 Concept Connection Example 2-6
Corporate Income Taxes
c. We dont 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

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 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

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Corporate Taxes
 Corporate Taxes

Dividends Paid to Corporations

Dividends paid to another corporation are
partially tax exempt

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Figure 2-2 Multiple Taxation

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Figure 2-3 Tax Loss Carry Back and
Forward

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