FINANCIAL STATEMENTS
In 1980 SEC adopted an “Integrated Disclosure System for 10-K reports required by SEC
and annual reports
To be included:
1. 4 basic audited fin. Statements
(balance sheet, income statement, statement of retained earnings, statement of cash
flows)
2. notes
3. auditor’s report
4. 5 year summary of selected data
5. market information on common stock for two years/management discussion of
analysis of fin. conditions of results of operations (projects working on, liquidity, etc.)
Problems with understanding fin. statements:
1. 2 sets of accounting rules (taxes and reporting)
2. change in accounting methods (could change from using LIFO to FIFO)
3. discretionary expenditures- (R & D, advertising, repair and maintenance)
-a company could try to look good one year by deferring these expenditures to
increase revenue in
the short term, however this could backfire in the long term..(example: drug
company putting off
R&D would not have new products in the pipeline).
4. non-recurring transactions (example:large cash outlays for expenditures such as write
down of inventory)
5. non-operating gains/losses (sale of property)
6. revenue and expense recognition that does not match cash flows (example: prepaid
expense)
Things to look for in earnings quality:
I.
SALES
1. Allowance for doubtful accounts (should be consistent in rates of change
between sales, AR, and loss provision.
2. Price vs. volume changes (ideal to have a combination of both)
3. Real vs. nominal growth (compare sales against inflation rate)
II.
COST OF GOODS SOLD
4. Cost flow assumption for inventory(what types are you using? Usually
LIFO more
conservative)
5. Base LIFO layer reductions (when you have oversold your inventory and dip
into older
Pieces bought at a cheaper price; CGS goes down which increases earnings
artificially)
6. Loss recognitions on write downs of inventory (see also item 13)
III.
OPERATING EXPENSES
7. Discretionary: look at if they are increasing or decreasing.
-research and development
-repair and maintenance
-advertising and marketing
8. Depreciation (depletion, amortization)
-methods
-estimates
9. Pension accounting-interest rates assumptions
IV.
NON-OPERATING REVENUES AND EXPENSES
10. Gains (losses) from sale of assets
11. Interest income
12. Equity income
13. Loss recognition’s on write-downs of assets (also see item 6)
14. Accounting changes
15. Extraordinary items
V.
OTHER ISSUES
16. Acquisitions and dispositions
17. Material changes in # of shares outstanding (if company buys back stock,
increases EPS)
FINANCIAL STATEMENTS
Income Statement
-presents revenues,expenses,net income and EPS for an accounting period
Balance Sheet
(Statement of Condition or Statement of Financial Position)
-shows fin. condition or fin. position of a company on a particular date
-summary of what a company owns and what it owes to others (liabilities) and to internal
owners (stockholders)
-includes comparative data (2 yr. Audited bal. Sheets/ 3 yrs. Income statements)
Statement of Cash Flows
–provides information about cash inflows and outflows
Statement of Shareholder’s Equity
-reconciliation in dollars and shares of all accounts from the stockholder’s equity section
Accounting Results Can Be Counterintuitive
Income isn't cash in hand
E.g.: Receivables
Depreciation
A Conventional Income Statement Format
Sales
Cost of Goods Sold
Gross Margin
Expense
Earnings Before
Interest & Taxes
Interest Expense
Earnings Before Tax
Tax
Net Income
$1,000
600
$400
230
$170
20
$150
50
$100
Sales - Revenue
Proceeds from sale of product or service (only)
COGS
Spending on things closely related to production
Material, labor, production overhead
Gross Margin
Profitability of production operations
Often expressed as a percent of sales
Expenses
Other spending - Marketing, finance, personnel
BALANCE SHEET
ASSETS
Cash
Accounts
Receivable
Inventory
CURRENT
ASSETS
$1,000
3,000
2,000
$6,000
Fixed Assets
Gross
$4,000
Accum Depr (1,000)
Net
$3,000
TOTAL ASSETS
LIABILITIES
Accounts
Payable
Accruals
$1,500
500
CURRENT
LIABILITIES
$2,000
Long Term Debt
Equity
$5,000
2,000
TOTAL CAPITAL
$7,000
TOTAL LIABILITIES
$9,000
AND EQUITY
$9,000
ASSETS = LIABILITIES + EQUITY
Arrangement in order of decreasing liquidity
ASSETS
Current Assets
Due within a year
Cash
Checking accounts + Currency
Accounts Receivable
Due from sales on credit
Offset-Allowance for doubtful accounts (bad debt reserve)
Writing off of uncollectibles
Overstatement of receivables
Inventory
Raw Material, WIP, Finished Goods
Offset - Inventory reserve
Writing off bad inventory
Overstatement of inventory
Fixed Assets
Long lived - depreciated
Stated Net of Accumulated Depreciation
If sold - cost is NBV
Year Income Statement
1
Deprec Exp $2,500
Balance Sheet
Gross
Accum Depr
Net
$10,000
(2,500)
$ 7,500
$10,000
(5,000)
$5,000
2
Deprec Exp $2,500
Gross
Accum Depr
Net
3
Deprec Exp $2,500
Gross
Accum Depr
Net
$10,000
(7,500)
$2,500
4
Deprec Exp $2,500
Gross
Accum Depr
Net
$10,000
(10,000)
-0-
LIABILITIES
Current Liabilities
Due within a year
Accounts Payable
Due from purchases on credit
Terms of sale
Stretching payables
Understatements
Notes Payable
Current maturities on long-term debt
Accrued
LONG TERM DEBT
Bonds and Loans
Debt generates interest expense - Increases risk of failure
EQUITY
Direct Investment by owners paying for stock
par value and paid in excess accounts
Retained Earnings
Example:
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
Accruals
Recognizes incomplete transactions
An example: A Payroll Accrual
Thurs
Fri
Sat
Sun
Mon
Tues Wed
Thurs
Payday
Fri Sat
Payday
End of Month
Close
First Month
Second Month
Working Capital
Current Assets - Current Liabilities
Supports routine operations
CAPITAL
LONG TERM DEBT
Bonds and Loans
Debt generates interest expense - Increases risk of failure
Leverage
Amplifies return on investment - both ways
EQUITY
Direct Investment by owners paying for stock
par value and paid in excess accounts
Retained Earnings
Example:
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
The Relationship Between Net Income and
Retained Earnings
Beginning Equity + Net Income - Dividends + Stock =
Ending Equity
Cash Flow Statements (sources & uses of funds)
CASH FLOW
Businesses run on cash, not on accounting profits.
It's possible to go out of business while making a profit.
THE STATEMENT OF CASH FLOWS
(THE STATEMENT OF CHANGES IN FINANCIAL POSITION)
Shows where money actually comes from and goes to
Developed from the basic income statement and balance sheet
Shows changes over time rather than absolute dollar amount of the
accounts at a point of time
Other Terminology for The Statement of Cash Flows
Funds flow
Sources and uses (applications) of cash or funds
Statement of changes in financial position
BASIC APPROACH
Since balance sheet balances the changes in balance sheet account must balance
( changes in cash outflows = changes in cash inflows)
Preparation of Statement:
 Calculate the changes of all balance sheet accounts
 List changes as inflows or outflows
 Categorize flows as
operating
financing
investing
 Inflows-Outflows=Change in Cash
Free Cash Flows
Net cash flow after reinvestments needed for growth
and to replace worn-out equipment
If free cash flow is negative, the firm must either borrow or raise
more equity capital to be viable in the long run.
CASH FLOW RULES
Asset Increase
Asset Decrease
Liability Increase
Liability Decrease
=
=
=
=
Use (outflow)
Source (inflow)
Source (inflow)
Use (outflow)
CASH FLOW IN BUSINESS
Organized into three activities
Operating Activities
Routine running of the company
Sales, investment income, collections, inventories,
wages, overhead, etc.
Paying interest on debt
Paying taxes
Investing Activities
Commitment of long term capital
Usually buying or selling fixed assets
Sale (purchase) of property, plant, equip
Sale (purchase) of other companies’ debt or equity
Repayment of loans to others
Financing Activities
Equity and long term debt transactions
Selling (buying) company stock and paying dividends
Borrowing and repaying loans--principal
(Note: Interest payment in operating activities)
Two Methods to Calculate & Present Cash Flows
Direct
Indirect
BUILDING THE STATEMENT OF CASH FLOWS
Belfry Company
Balance Sheet
For the Period Ended 12/31/00
Cash
Accts. Receivable
Inventory
CURRENT
ASSETS
Fixed Assets
Gross
Accum. Depr.
Net
TOTAL ASSETS
ASSETS
12/31/99
$1,000
3,000
2,000
12/31/00
$1,400
2,900
3,200
$6,000
$7,500
$4,000
(1,000)
$3,000
$9,000
$6,000
(1,500)
$4,500
$12,000
LIABILITIES
$1,500
$2,100
500
400
$2,000
$2,500
$5,000
$6,200
2,000
3,300
$7,000
$9,500
Accts. Payable
Accruals
CURRENT LIABIL.
Long-term debt
Equity
TOTAL CAPITAL
TOTAL LIABILITIES
AND EQUITY
$9,000
$12,000
Belfry Company
Income Statement
For the Period Ended 12/31/00
Sales
COGS
Gross Margin
$10,000
6,000
$ 4,000
Expense
Depreciation
EBIT
Interest
EBT
Tax
Net Income
$ 1,600
500
$ 1,900
400
$ 1,500
500
$ 1,000
Cash
Operating
Operating
400
100
(1200)
Investing
Operating
(2000)
500
Operating
Operating
600
(100)
Financing
Financing
1200
1300
Cash Flow Statement
Indirect Method:
OPERATING ACTIVITIES
Net income
$1,000
Depreciation
500
Net changes in
current accounts
(600)
Cash from operating
activities
$ 900
Detail of Changes in Current Accounts
Account
Source/(Use)
Receivables
$ 100
Inventory
(1,000)
Payables
600
Accruals
(100)
$ (600)
INVESTING ACTIVITIES
Purchase of fixed assets
($2,000)
(Note: excludes cash)
FINANCING ACTIVITIES
Increase in long-term debt
$1,200
Sale of stock
800
Dividend paid
(500)
Cash from financing activities
$1,500
UNDERSTANDING THE EQUITY ACCOUNT
Amount
Activity
Net income $1,000
Operating
Stock sale
800
Financing
Dividend
(500)
Financing
Change in equity
$1,300
Net Cash Flow
$ 400
COMMON SIZE STATEMENTS
Ratios of income statement line items to sales revenue
Facilitates operating comparisons
over time and between
companies of different sizes
COMMON SIZE STATEMENTS
Example:
Alpha
Sales Revenue
Cost of Sales
Gross Margin
Expenses
EBIT
Interest
EBT
Tax
Net Income
$
$2,187,460
1,203,103
$ 984,357
505,303
$ 479,054
131,248
$ 347,806
118,254
$ 229,552
* Operating differences worth investigating
Beta
%
100.0
55.0
45.0
23.1
21.9
6.0
15.9
5.4
10.5
$
$150,845
72,406
$ 78,439
39,974
$ 38,465
15,386
$ 23,079
3,462
$ 19,617
%
100.0
48.0 *
52.0
26.5 *
25.5
10.2 *
15.3
2.3 *
13.0
TAXES
Tax Bases and Taxing Authorities
Income - Federal, State, a few cities
Wealth - Real estate taxes - Cities and counties
Consumption - Sales and excise taxes - all
The Total Effective Income
Tax Rate
State tax is deductible from federal tax
Taxable Income for State Tax
$ 100
State tax @ 10%
10
Taxable Income for Federal Tax
$ 90
Federal Tax @ 30%
27
Net After Tax
$ 63
Total Tax
$ 37
In general: TETR = Tf + Ts(1 - Tf)
Progressive Tax Systems
The U.S. federal tax system is progressive in that the tax
rate increases with income.
In a traditional progressive system a high income taxpayer retains the
benefit of low rates on early income
Tax Schedules (Tables) and Tax Brackets
Hypothetical Example:
Bracket
0 - $5,000
$5,000 - $15,000
over $15,000
Tax Rate
10%
15%
25%
Brackets are ranges of income through which the tax rate is constant.
Marginal and Average Tax Rates
Marginal tax rate - the rate paid on the next dollar of income
Average tax rate - the percent of total income paid in taxes
The marginal rate is relevant for investment decisions because
investments are generally made after basic needs are provided
PERSONAL CAPITAL GAINS(and LOSSES)
Income is either ordinary or capital gain/(loss)
Historically, capital gains taxed at lower rates as an incentive to investment.
Personal Capital gain rate is currently capped at:
28%.- Mid-term gains
20%- Long-term gains
A maximum of $3,000 in capital losses can offset ordinary income in a year.
PERSONAL TAX SCHEDULES (1998)
Taxpaying unit is a household, usually a family
Personal Tax Schedules
Single Individuals
Income
Rate
0 - $25,350
15%
$25,350 - $61,400
28%
$61,400 - $128,100
31%
$128,100 - $278,400
36%
over $278,400
39.6%
Married Couples
Filing Jointly
Income
0 - $42,350
$42,350 - $102,300
$102,300 - $155,950
$155,950 - $278,450
over $278,450
Rate
15%
28%
31%
36%
39.6%
The Marriage Penalty
Single people pay higher rates sooner, but a two income family pays more tax than two
single people earning the same total income
Exempt Income
Exempt from taxation:
Interest on municipal bonds
Exclude from calculations
Taxable Income
Gross income less: exemption of $2,700 (in 1998)
per person, and deductions of
* mortgage interest
* local taxes (income and property)
* charitable contributions
 or a standard deduction
CALCULATING PERSONAL TAXES
Example: The Smith family had the following in 1998:
Income:
Deductions:
Salaries:
Joe
$45,000
Mortgage Interest
$12,000
Sue
42,000
Property Tax
1,800
Interest on savings acct 2,000
State income tax
3,500
Interest on IBM bonds
800
Charitable donations
1,200
Interest on Boston Bonds 1,200
Dividends - Gen Motors
600
Long-term Capital loss
on property
(3,000)
Exemptions:
4
Long-term Capital gain
on stock
2,000
Calculate their taxable income and tax liability. What are their marginal and average
tax rates?
Solution:
Ordinary income:
Salaries
Interest
Dividends
$87,000
2,800
600
$90,400
Net capital gain or loss:
Loss on property ($3,000)
Gain on stock
2,000
Net capital loss
($1,000)
Total Income
$89,400
Deductions:
Mortgage interest
Taxes
Charity
Total deductions
$12,000
5,300
1,200
$18,500
Exemptions:
$2,700 x 4 =
$10,800
Taxable Income
$60,200
Use the married filing jointly schedule as follows:
15% of the entire first bracket
$42,350 x .15 =
$6,353
28% of the amount in the second bracket ($60,200 - $42,350) x .28 = 4,970
Tax Liability
$11,323
Average tax rate: $11,323/$60,200 = 18.8%
Marginal tax rate = bracket rate = 28%
TAX RATES AND INVESTMENT DECISIONS
If comparing corporate (interest taxable) and municipal (interest tax exempt) bonds
then
Must state rates on same basis.
Multiply the corporate rate by one minus the investor's marginal tax rate
Example:
The Smith family (28% bracket) has a choice between an AT&T bond paying
11% and a Boston bond paying 9%.
Solution:
AT&T after tax = 11% x (1 – .28) = 7.92% < Boston = 9%
Therefore prefer the Boston bond if risks are similar.
If marginal tax rate is 15%
11%  (1 – .15) = 9.35%
then prefer AT&T
High bracket taxpayers tend to be more interested in tax exempt bonds than
those with lower incomes.
CORPORATE TAXES
Income is the business's revenue.
Deductions are costs and expenses.
Personal exemptions don't exist
Taxable income is Earnings Before Tax (EBT)
Income per financial books vs tax income
CORPORATE CAPITAL GAINS (and LOSSES)
Corporate capital losses are deductible only against capital gains. Net capital losses
may be carries back and applied against net gains in the prior three years. Any
remaining net capital losses may be carried forward for five years and applied
against gain in those years. Capital gains tax rate is the same as the ordinary.
Corporate Income Tax Schedule
Income
0 - $50,000
50,000 - $75,000
$75,000 - $100,000
$100,000 - $335,000
$335,000 - $10,000,000
$10,000,000 - $15,000,000
$15,000,000 - $18,333,333
over $18,333,333
Rate
15%
25%
34%
39%*
34%
35%
38% *
35%
Tax Calculation
$0 + (15% x amount over $0)
$7500 +(25% x amount over $50,000)
$13,750 +(34% x amount over $75,000)
$22,250 + (39% x amount over $100,00)
$113,900 +(34% x amount over $335,000)
$3,400,000 + (35% x amount over $10,000,000)
$5,150,00 +(38% x amount over $15,000,000)
35% x taxable income
The benefits of the 15 percent and 25 percent rates are phased out by imposing an
additional 5 percent tax on taxable income between $100,000 and $335,000. The
benefit of the 34% rate on taxable income between $335,000 and $10,000,000 is
phased out by imposing an additional 3% on taxable income between $15,000,000
and $18,333,333. The effect of these provisions is that corporations with taxable
incomes in excess of $18,333,333 pay a flat rate of 35% on all taxable income.
Notice the up and down rates. Is the system progressive?
Goals of the system:
1. Progressive: income under $10M taxed at 34%
income over $10M taxed at 35%.
2. Lower rates on incomes up to $75,000.
3. Higher income taxpayers pay the targeted rates
on their whole incomes.
Surtaxes of 5% and 3% take away the benefit of low early rates as income
increases
Corporate Tax Examples
Example :
Tax for a corporation making EBT of $280,000
Solution: 50,000  .15
$25,000  .25
$25,000  .34
$180,000  .39
=
=
=
=
$ 7,500
6,250
8,500
70,200
$92,450
Corporate Tax Examples
Example:
Tax for a corporation making EBT of $500,000.
Solution: Between $335,000 and
$10 million, the overall tax rate is 34%.
($500,000-$335,000) x .34 + $113,900 = $170,000
Corporate Tax Examples
Example :
Tax for a corporation making EBT of $16 million
Solution: The system recovers those benefits to an overall 34% rate 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
Over $18,333,333, calculate a flat 35%
3
TAXES AND FINANCING
The U.S. tax system favors debt financing because interest is tax deductible and
dividends are not.
DEBT
EBIT
$120
Interest
20
EBT
$100
Tax @ 30% 30
EAT
$ 70
Dividends
Net RE add $70
EQUITY
$120
$120
36
$ 84
20
$ 64
DIVIDENDS PAID TO CORPORATIONS
Tiered ownership can result in multiple taxation
PREFERRED DIVIDENDS PAID TO
CORPORATIONS
Ownership
Exemption
<20%
20% - 80%
>80%
70%
80%
100%
TAX LOSS CARRY BACK AND CARRY FORWARD
YEAR
1
2
3
4
EBT
$100 $100 ($250) $100
Tax (30%)
30
30
30
EAT
$ 70 $ 70 ($250) $ 70
($100)
Adjusted
EBT
Tax
EAT
$0
0
$0
($100)
$0
0
$0
Total
$50
90
($40)
($50)
$0
0
$0
$ 50
15
$ 35
$50
15
$35
Tax Loss Carry Forward and Carry Back
Over the four year period paying $90 tax on earnings of $50 - impossible.
Losses can be carried back two years and carried forward twenty (fifteen) years.