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
– 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 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 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 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
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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 firm’s 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
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
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Concept Connection Example 2-1
Writing Off a Large Uncollectable Receivable
Gross accounts receivable
Bad-debt reserve
Net accounts receivable
Need to Write Off
Reserve
Expense
Reestablish Reserve (5%)
Profit Reduction
$5,650
(290)
$5,360
$435,000
290,000
$145,000
260,750
$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, 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
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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
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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
Revenue
Cost (NBV)
Profit contribution: EBT
Tax (30%)
Contribution: net income
Cash flow
$4,000
2,500
$1,500
(450)
$1,050
Cash Flow
$4,000
(450)
$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 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
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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
Sue
Interest on savings acct
Interest on IBM bonds
Interest on Boston Bonds
Dividends - Gen Motors
$55,000
52,000
2,000
800
1,200
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:
Salaries
$107,000
Interest
2,800
$109,800
Net capital gain or loss:
Loss on property ($3,000)
Gain on stock
2,000
Net capital loss
($1,000)
Total Income $108,800
(excludes dividends)
Deductions:
Mortgage interest $12,000
Taxes
5,300
Charity
1,200
$18,500
Exemptions:
$3,800 x 4 =
$15,200
Taxable Income
$75,100
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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
($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)
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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)
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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 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
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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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