Chapter 02 Financial Background A Review Of Accounting, Financial Statements, And Taxes

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

The Nature of Financial Statements
Financial statements are numerical representations of a firm’s activities for an accounting period
Provide a picture of what is happening within the firm and between the firm and the rest of the world

Is Income “Income”?
Net income does not represent the cash a firm has in its pocket
Two major differences between cash and net income are
Accounts receivable—when a credit sale has occurred income is generated but cash is not received until the accounts receivable is paid
Depreciation—is the prorating of an asset’s cost over its service life

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

The Accounting System
A firm’s financial books are a collection of records in which money transactions are recorded
They are separated into a series of ‘accounts’
Transactions include activities such as
Selling product
Buying inventory
Paying wages
Borrowing money
Each transaction is recorded by an entry into the books

The Double Entry System
Each entry has two parts—with each side being made to a different account
The entry must balance
For example, if we borrowed $1,000 to buy a machine, the entry would involve increasing an asset account by $1,000 and increasing a liability account by $1,000

Accounting Periods and Closing the Books
Books are closed by updating the period’s transactions in the accounting system and creating financial statements
Implications
Last period’s statements don’t say anything about what WILL happen next year
However, they can be used to predict what might happen
Stocks and Flows
The income statement reflects flows of money over a period of time
The balance sheet represents stocks of money at a point in time

The Income Statement
Sales (AKA: revenue)
Total receipts from selling goods from normal business operations
If the firm receives money from activities outside normal business operations, it will be recorded as other income
Cost and Expense
Both represent money spent to do business
Costs of Goods Sold—represent money spent on items closely related to the production of the product being sold
For instance, in a retail business, it represents the wholesale cost of the product
Expense—represent spending on an item that isn’t necessarily closely related to production, such as marketing or research

Gross Margin
Represents sales revenue less cost of goods sold
Fundamental measure of profitability
Interest and Earnings Before Interest and Taxes
Interest—the price the firm pays for borrowing money
Earnings before interest and taxes (EBIT)—a business’s profit before consideration of financing charges
AKA operating profit
Helps judge the strength of business operations without considering the interest expense a leveraged firm pays

Earnings Before Tax, and Tax
Earnings before taxes (EBT) represent gross margin less all expenses except taxes
Tax refers to income taxes on EBT
Doesn’t necessarily mean the tax actually due
Net Income
Represents the “bottom line”—calculated by subtracting tax from EBT
Belongs to the company’s owners and can be paid out as dividends or retained

The Balance Sheet
Shows where all the business’s money has come from and what it’s been used for
All the sources of money and all the uses must balance
A firm’s money sources include creditors and owners
Borrowing money from a creditor creates a liability

The Balance Sheet
Has two sides
Assets; liabilities and equity
Assets = liabilities + equity
AKA statement of financial position
The ease with which an asset becomes cash is referred to as liquidity
Both assets and liabilities are arranged in order of decreasing liquidity
For instance, current assets are listed first, with cash being the first current asset listed

The Balance Sheet—Assets
Cash
Money in checking accounts plus currency on hand
Marketable securities are liquid investments held instead of cash
Short-term, modest return, low risk
Used by larger companies
Accounts Receivable
Represent credit sales that have not yet been paid
Bad Debt Reserve: a small percentage of credit sales that will never be paid
Writing Off a Receivable: when a receivable is known to be uncollectable, the balance in accounts receivable is reduced by that amount

Inventory
Product held for sale in the normal course of business
Manufacturing firms will have raw materials, work-in-process and finished goods
Work-In-Process Inventories: as inventory moves through the production process, value added by the process is included in the inventory balance sheet amount
The Inventory Reserve: some inventory may be unusable; thus inventory balances are usually reported net of a reserve
Similar to bad debts expense associated with accounts receivable
Writing Off Bad Inventory

Overstatements
Overstatement of accounts receivable and inventory can be a significant problem to users of financial statements
If these accounts are overstated the firm’s value is less than what is being reported
Can also mean firm is not managed efficiently

Current Assets
Assets that can be expected to become cash within one year
Include cash, accounts receivable and inventory
All the money received from normal business operations flows through these accounts

Fixed Assets
Predominant item includes property, plant and equipment (PPE)
‘ Fixed’ means long-lived—useful life of at least a year
Depreciation
An artificial accounting device that spreads the cost of an asset over its estimated useful life according to the matching principle
Sometimes depreciation can be front-loaded using an accelerated depreciation method
Financial Statement Representation
Depreciation is accumulated over an asset’s life; thus fixed assets can be represented NET of accumulated depreciation

Fixed Assets
Disposing of a Used Asset
An asset may be salable at a value more or less than the net asset value on the books
A gain (loss) on disposal is taxed (tax deductible)
The Life Estimate
An asset remaining in use beyond its depreciated life is said to be fully depreciated
Tax Depreciation and Tax Books
Government allows businesses to use two sets of books
Tax books are those generated according to the tax rules (usually result in lower taxable income and lower taxes)
Books used for financial reporting purposes usually report higher profits due to differing depreciation method
Difference in taxes is placed in a deferred tax account on the financial books

The Balance Sheet—Liabilities
Represent what the company owes to creditors
Accounts payable
Represent what the firm owes when vendors deliver product without demanding immediate payment
Usually arises with the purchase of inventory
Terms of Sale
The length of time allowed until payment is due on a credit sale
Common terms involve payment within 30 days with a discount (such as 2%) for payment within a shorter time period—stated as 2/10, n/30, for instance
Delaying payment is known as stretching payables or leaning on the trade
Abuse of vendor’s terms may result in revocation of credit privileges

Accruals
Used to recognize expenses and liabilities for incomplete transactions
A Payroll Accrual Example
Assume an employer pays its employees every Friday afternoon for working during the week
If the last day of the month falls on a Wednesday and the books have to be closed, two things arise
First, employees have worked through Wednesday and won’t be paid until Friday—this liability must be reflected on the balance sheet
Second, the work that went into that month should be reflected in that month’s costs and expenses
The solution is a month-end accrual representing the amount of the three days’ wages

Current Liabilities
Items requiring payment within one year, such as Accounts Payable, Accruals, Notes Payable, etc .
Working Capital
Collectively current assets are known as gross working capital
Net working capital = current assets – current liabilities

Long-Term Debt
Typically the most significant non-current liability
Usually consists of bonds and long-term loans
Leverage
The use of debt as a source of funds
If things are going well, the use of leverage can enhance the return on an entrepreneur’s own investment
Fixed Financial Charges
Borrowing money costs money in the form of interest
Interest charges are fixed
If the business does poorly, it still owes the same amount of interest it would have had it performed well
Many businesses have gone bankrupt due to their inability to pay fixed financial obligations

The Balance Sheet—Equity
Represents funds supplied to businesses by their owners either through
Direct investment or
Retained earnings
The Representation of Direct Investment by Owners
Represent the total amount of money paid for an issue of stock
Common stock account represents an arbitrary par value amount on the books
Paid in excess account represents the amount paid over the par value

Retained Earnings
A company’s profits can be paid to its owners (generally through dividends) or retained
Money retained for reinvestment still belongs to the owners
Does not represent a reserve of cash
Shows all the earnings ever retained by the firm

The Relationship Between Net Income and Retained Earnings
If Net Income is not distributed and no new equity investments are made
Beginning equity + net income = ending equity
If dividends are paid
Beginning equity + net income – dividends = ending equity
If new equity is raised
Beginning equity + net income – dividends + stock = ending equity

Preferred Stock
A cross between debt and common equity, a hybrid
Legally it’s classified as equity
Total Capital
The sum of long-term debt and equity
Generally used to finance long-term assets
Total Liabilities and Equity
Sum of the right-hand side of the balance sheet
Must always equal total assets

Taxing Authorities and Tax Bases
In the U.S. there are typically three taxing levels
Federal
State
Local

Taxing Authorities and Tax Bases
A tax base is the item that is taxed, usually
Income Tax
An individual (or corporation) pays a fraction of income in a particular time period to the taxing authority
Wealth Tax
Based on the value of certain types of assets, such as real estate
Consumption Tax
Based on the amount of certain goods we use, such as a sales tax

Income Taxes—The Total Effective Tax Rate
Total effective tax rate (TETR) is the combined rate to which the taxpayer is subject
State tax is deductible from income in the calculation of federal tax
Can be calculated as
TETR = T federal tax rate + T state tax rate (1 – T federal tax rate )
For example, if a taxpayer is subject to a 30% federal tax rate and a 10% state tax rate, the TETR is
30% + 10%(1 – 30%) = 37%

Progressive Tax Systems, Marginal and Average Rates
A progressive tax system is characterized by higher tax rates on incrementally higher income
Example: U.S. federal income tax system
A tax bracket is a range of income in which the tax rate is constant
A marginal tax rate is the rate that will be paid on the next dollar of income a taxpayer earns
An average tax rate is the percentage of total income a person pays in taxes

Progressive Tax Systems, Marginal and Average Rates--Example Q: Given the following tax brackets, calculate the total taxes (in dollars) a taxpayer earning $11,000 will pay. Also calculate the marginal and average tax rates. A: Since the taxpayer earned above $5,000 (but less than $15,000) she will pay two different tax rates. The first $5,000 will be taxed at 10%, so she will owe $500 on that amount. However, she earned an additional $6,000 which will be taxed at the 15% tax rate, for a tax of $900. Thus, her total tax in dollars is $500 + $900, or $1,400. Her marginal tax rate is 15%, or what she would pay in taxes on the next dollar of income. Her average tax rate is 12.7%, or $1,400  $11,000. Example 25% Over $15,000 15% $5,000 - $15,000 10% 0 - $5,000 Tax Rate Bracket

Capital Gains and Losses
Ordinary income includes wages, business profits, dividends and interest
Since business profits can be positive or negative, ordinary income can also be an ordinary loss
Capital gain (loss) income arises when an asset that’s held for investment is sold for more (less) than was paid for it

Capital Gains and Losses
The Tax Treatment of Capital Gains and Losses
Historically capital gains have been taxed at lower rates than ordinary income in order to encourage investment
Short-term capital gains are not eligible for favorable tax treatment
Gains on assets held for more than one year qualify for long-term treatment and the tax rate is capped at 20% for individuals
Can represent a considerable savings since the top personal tax bracket is 38.6%
Capital losses can be used to offset capital gains
Corporations do not receive favorable rates on capital gains

Income Tax Calculations
Income taxes are paid by both people and corporations according to the same basic principles
Tax is levied on a base of taxable income
Gross income less certain deductions
Rate schedules for corporations and people are very different as are the rules for calculating taxable income

Personal Taxes
In 2001 Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001
Purpose was to stimulate economy by lowering personal tax rates gradually over five years
Taxes on people are called personal or individual taxes
Separate schedules exist for single individuals, married couples filing jointly, married people filing separately and certain heads of household
Rate schedules are adjusted for inflation annually

Table 2.4

Personal Taxes
Taxable Income
Some income items are exempt from taxation, including interest on municipal bonds
Taxable income is total non-exempt income less exemptions and deductions
Deductions are personal expenditures that the tax code allows to be subtracted before calculating taxes owed
Exemptions are fixed amounts that can be deducted to arrive at taxable income

Personal Taxes—Example Q: The Smith family had the following income in 2003: During 2003 they sold an investment property for $50,000 that they had purchased three years earlier for $53,000. They also sold some AT&T stock for $14,000 for which they had paid $12,000 five years before. They paid $12,000 interest on their home mortgage and $1,800 in real estate taxes. State income tax of $3,500 was withheld from their paychecks during the year. They contributed $1,200 to their church. They have two children living at home. Assume the exemption rate is $3,050 per person. What is their taxable income and their tax liability? Further, what are their marginal and average tax rates using the tax rates for the married, filing jointly column in Table 2.4? Example 600 Dividends from General Motors 1,200 Interest on Boston bonds 800 Interest on IBM bonds 2,000 Interest on savings account 42,000 Sue $45,000 Joe Salaries

Personal Taxes—Example A: The income on the Boston bonds is exempt from taxation; thus their taxable income is $90,400, including salaries, interest and dividend income. They had a capital loss on their investment property of $3,000 and a capital gain of $2,000 on the sale of stock. Thus they have a net capital loss of $1,000. Since this is less than $3,000 it can be used in its entirety to offset ordinary income. Therefore their total income is $89,400 or $90,400 - $1,000. Their deductions total $18,500 and include mortgage interest of $12,000, state and real estate taxes of $5,300 and a charitable deduction of $1,200. They also have exemptions totaling $12,200, or $3,050 x 4. Their taxable income is their total income less total deductions and total exemptions, or $58,700. Example

Personal Taxes—Example A: Their tax liability is as follows: Their average tax rate is 16.3%, or $9,556  $58,700 while their marginal tax rate is 27%. Example $9,556 Tax liability $3,038 27% of the amount in the third bracket ($58,700 - $47,450) x .27 $5,318 15% of the amount in the second bracket ($47,450 - $12,000) x .15 $1,200 10% of the entire first bracket $12,000 x 0.10

Personal Taxes
Tax Rates and Investment Decisions
When comparing investments in municipal bonds (muni) vs. corporate bonds, an adjustment must be made due to the fact that interest on municipal bonds are not taxed
If a muni is paying 8% and a corporate bond of the same risk level is also paying 8%, the muni is a better deal after considering taxes
However, if the rates differ, the corporate bond must be adjusted to be after tax
Multiply by (1 – marginal tax rate)

Corporate Taxes
Are similar in principle to personal taxes
Total income is the business’s revenue
Deductions are the charges and expenditures required to run the company
Exemptions are not allowed
A company’s Earnings Before Tax (EBT) represent a corporation’s taxable income
Corporate tax rates do not consistently rise as taxable income rises
With personal taxes taxpayers pay a lower rate on income in the bottom brackets
However, corporate tax tables are fixed so that corporations generating high incomes pay a constant rate on all their income

Table 2.5

Corporate Taxes—Example Q: Calculate, using the corporate tax rates in Table 2.5, the tax liability for a corporation making EBT of $280,000. A: Applying the corporate tax table results in the following tax liability: Example $92,450 Total $70,200 $180,000 x .39 $8,500 $25,000 x .34 $6,250 $25,000 x .25 $7,500 $50,000 x .15

Corporate Taxes
Taxes and Financing
The corporate tax system favors debt financing over equity financing
Interest payments made to debt investors are tax deductible
Dividend payments to equity investors are not tax deductible
If, for example, two companies generated the same EBT, but one firm were financed entirely with debt, the firm with debt financing would have a lower tax liability

Corporate Taxes
Dividends Paid to Corporations
Dividends paid to another corporation are partially tax exempt
The percentage of dividends deductible by the receiving corporation depends on the percentage ownership that corporation has of the dividend-paying corporation
Tax Loss Carry Back and Carry Forward
Business losses can be carried backward or forward in time to offset taxes

Chapter 02 Financial Background A Review Of Accounting, Financial Statements, And Taxes

by Alamgir Alwani on Jan 12, 2009

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Chapter 02 Financial Background A Review Of Accounting, Financial Statements, And Taxes Presentation Transcript