Chapte
2
Review of Accounting,
Financial Statements, and
Income Taxes
Slides Developed by:
Terry Fegarty
Seneca College
Chapter 2 – Outline (1)
• Accounting Systems and Financial Statements
 The Nature of Financial Statements
 Accounting Periods
• The Income Statement
• The Balance Sheet
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The Balance Sheet—Assets
Tax Amortization and Tax Books
The Balance Sheet—Liabilities
The Balance Sheet—Equity
• The Statement of Cash Flows
 Constructing the Statement of Cash Flows
 Free Cash Flows
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Chapter 2 – Outline (2)
• Income Taxes
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Income Tax Authorities and Tax Bases
Income Tax Formulas
Income Tax Calculations
Progressive Tax System, Marginal and
Average Rates
Personal Tax on Investment Income
Tax Rates and Investment Decisions
Capital Gains and Losses
Tax on Dividends
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Chapter 2 – Outline (3)
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Corporate Taxes
How Much Tax Will a Corporation Pay?
Corporate Tax Rates
Effect of Corporate Taxes
Corporate Taxes and Financing
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The Nature of Financial
Statements
• Financial statements are numerical
representations of a firm’s activities for
an accounting period
 Provide picture of what’s happening within
firm and between firm and rest of the world
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The Nature of Financial
Statements
• The Three Financial Statements
 Income statement
 Balance sheet
 Statement of cash flows
• Financial statements are associated with
particular accounting periods
 usually months, quarters, and years—during
which accounting system accumulates
transactions
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Financial Statements and
Accounting Periods
• The income statement
 reports revenue earned and costs and expenses
incurred over accounting period. The difference is
profit
• The balance sheet
 reports that, at end of accounting period, company
owns certain assets and owes certain liabilities,
Difference is owners’ equity
• The statement of cash flows
 reports cash receipts and cash disbursements
over accounting period. Difference is net cash flow
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Table 2.1:
The Income Statement
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The Income Statement (1)
• Sales (AKA: revenue)
 Total receipts from selling goods from normal
business operations
• If firm receives money from activities outside normal
business operations, it will be recorded as other income
• Cost of Goods Sold
 Represents money spent on items related to
production or purchase of product being sold
• For instance, in retail business, represents wholesale cost
of product
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The Income Statement (2)
• Gross Margin
 Represents Sales revenue less Cost of goods sold
• Fundamental measure of profitability
• Expenses
 Represent spending on items that are not closely
related to production, such as marketing or
accounting
• Both Expenses and Cost of goods sold may include
amortization
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The Income Statement (3)
• Earnings Before Interest and Taxes (EBIT)
 Business’s profit before financing charges
• AKA: Operating profit
• Helps judge strength of business operations without
considering interest expense on debt
• Interest Expense
 Price firm pays for borrowing money
• Earnings Before Tax (EBT)
 Represent Gross margin less all expenses except
taxes
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The Income Statement (4)
• Tax
 refers to income taxes on EBT
• Doesn’t necessarily mean tax actually due
• Net Income
 Represents “bottom line”—calculated by
subtracting tax from EBT
• AKA: Earnings after Tax (EAT)
 Belongs to company’s owners and can be paid out as
dividends or retained by company
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Table 2.2:
The Balance Sheet
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The Balance Sheet
• Shows where business’s money has come
from and what it’s been used for
 All sources of money and all uses must
balance
• Money sources include creditors and
owners
 Borrowing money from creditor creates
liability
• Has two sides
 Assets (=) liabilities + equity
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The Balance Sheet
• Liquidity—ease with which an asset
becomes cash
 Assets and liabilities are arranged in order of
decreasing liquidity
• For instance, current assets are listed first, with
cash being first current asset listed
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The Balance Sheet—Assets (1)
• Current Assets
 Assets that can be expected to become cash
within one year
 Include Cash, Accounts receivable and
Inventory
 All money received from normal business
operations flows through current accounts
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The Balance Sheet—Assets (2)
• Cash
 Money in chequing accounts plus currency on
hand
 Marketable securities or cash
equivalents—liquid investments held
instead of cash
• Short-term, modest return, low risk
• Used by larger companies
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The Balance Sheet—Assets (3)
• Accounts Receivable
 Represent credit sales that have not yet been
paid
• Allowance for doubtful accounts: provision for
credit sales that will never be paid
• Writing off a receivable: when receivable is
known to be uncollectible, accounts receivable
reduced by that amount
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The Balance Sheet—Assets (4)
• Inventory
 Product held for sale in normal course of
business
• Manufacturing firms will have raw materials,
work-in-process and finished goods
• The inventory allowance: inventory balances
are usually reported net of an allowance for
unusable inventory
• Writing off bad inventory: when inventory is
identified as missing, damaged, or obsolete,
balance sheet inventory account reduced to reflect
the loss
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The Balance Sheet—Assets (5)
• Overstatements
 Overstatement of accounts receivable and
inventory can be significant problem to users
of financial statements
 If these accounts are overstated, firm’s value
and net income are less than what are being
reported
 Can also mean firm is not managed
efficiently
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The Balance Sheet—Assets (6)
• Capital Assets
 Predominant item includes property, plant
and equipment (PPE)
 ‘Capital’ implies long-lived—useful life of at
least one year
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The Balance Sheet—Assets (7)
• Capital Assets—Amortization
 Accounting procedure that spreads cost of
capital asset over its estimated useful life
 Asset remaining in use beyond its amortized
life is said to be fully amortized
 Sometimes amortization can be front-loaded
using an accelerated amortization method
 Balance Sheet Presentation
• Capital assets presented net of accumulated
amortization
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Table 2.3:
Capital Asset
Amortization
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Tax Amortization and Tax Books
• Government allows businesses to use
two sets of books
 Tax books—generated according to the tax
rules (usually result in lower taxable income
and lower taxes)
 Financial books—used for financial
reporting purposes
• Usually report higher profits due to differing
amortization method
 Difference in taxes is placed in deferred tax
account on financial books
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The Balance Sheet—Liabilities (1)
• Represent what company owes to creditors
• Current Liabilities
 Items requiring payment within one year, such as
Accounts payable, Accruals, Notes payable, etc.
• Working Capital
 Total current assets—known as gross working
capital
 Net working capital = Current assets – Current
liabilities
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The Balance Sheet—Liabilities (2)
• Accounts payable
 What firm owes when it buys from vendors on credit
(called trade credit)
• Usually arises with purchase of inventory
 Terms of Sale
• Length of time allowed until payment is due on credit sale
• May include discount for early payment
• 2/10, n/30, for instance
 Delaying payment—known as stretching payables
or leaning on the trade
• Abuse of vendor’s terms may result in cancellation of
credit privileges
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The Balance Sheet—Liabilities (3)
• Accruals
 Expenses and liabilities for incomplete
transactions at end of accounting period
 Common examples—unpaid wages, interest,
taxes
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The Balance Sheet—Liabilities (4)
• Long-term Debt
 Usually consists of bonds and long-term loans
 Leverage
• Use of debt as a source of funds
• If things are going well, leverage can improve return on
owner’s investment
 Fixed Financial Charges
• Interest charges on debt are fixed
• If business performs well or poorly, owes same amount of
interest
• Many businesses have gone bankrupt due to inability to pay
fixed financial obligations
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The Balance Sheet—Equity (1)
• Funds supplied to business corporations by
their shareholders either through
 Direct investment or
 Retained earnings
• Direct Investment by Shareholders
 Total amount of money paid for an issue of shares
• Common shares
• Common shareholders own the corporation
• Preferred shares
• A cross between debt and common shares
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The Balance Sheet—Equity (2)
• Retained Earnings
 Company’s profits can be paid to its
shareholders (generally through dividends)
or retained in the business
• Money retained for reinvestment still belongs to
owners
 Does not represent a cash balance
 Shows all the earnings ever retained by the
firm
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The Balance Sheet—Equity (3)
• The Relationship Between Net
Income and Equity
 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 + new
shares issued = ending equity
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The Statement of Cash Flows
• Income does not represent cash in firm’s bank
account
• The Statement of Cash Flows provides info
on movement of cash in and out of company
• Constructed from Balance Sheet and Income
Statement
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The Statement of Cash Flows
• Cash Flow Rules
 To construct a statement of cash flows
• Cash income  cash inflow
• Cash loss  cash outflow
• Asset increase  cash outflow
• Asset decrease  cash inflow
• Liability increase  cash inflow
• Liability decrease  cash outflow
• Equity increase  cash inflow
• Equity decrease  cash outflow
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The Statement of Cash Flows
• Statement of Cash Flows is organized to
show
 Operating activities
• Running business on day-to-day basis
 Investing activities
• When firm buys or sells things to do business
• Includes purchases and sales of long-term financial
assets
 Financing activities
• When firm borrows money, pays off loans, sells
shares or pays dividends
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Constructing the Statement of
Cash Flows—Example
Belfry Company
Belfry Company
Balance Sheet
As of 31/12/X2
Income Statement
For the period ending 31/12/X2
Sales
COGS
Gross margin
Expenses
Amortization
EBIT
Interest
EBT
Tax
Net Income
Example
Assets
Cash
Accounts receivable
Inventory
CURRENT ASSETS
Capital assets
Gross
Accumulated amortization
Net
TOTAL ASSETS
Liabilities and
Accounts payable
Accruals
CURRENT LIABILITIES
Long-term debt
Equity
TOTAL LIABILITIES AND EQUITY
31/12/X1
31/12/X2
$
1,000 $
1,400
3,000
2,900
2,000
3,200
$
6,000 $
7,500
$
4,000
-1,000
$
3,000
$
9,000
Equity
$
1,500
500
$
2,000
$
5,000
$
2,000
$
9,000
$
$
$
$
$
$
$
$
6,000
-1,500
4,500
12,000
2,100
400
2,500
6,200
3,300
12,000
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$
$
$
$
$
$
10,000
6,000
4,000
1,600
500
1,900
400
1,500
500
1,000
Also assume firm paid
a $500 dividend and
sold shares for $800
during the year.
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Constructing the Statement of
Cash Flows
• Operating activities
 Involve Income Statement and Balance
Sheet current accounts
 Involves activities firm does on day-to-day
basis such as
• Buying inventory
• Producing and selling product
• Paying expenses and taxes
• Collecting credit sales
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Focus of activities
is generating net
income—the
beginning of a
cash flow
statement.
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Constructing the Statement of
Cash Flows—Example
For Belfry, cash from operating activities is:
Net Income
Example
+ Amortization
= Operating income
+ increase in receivables
$1,000
$500
$1,500
$100
- increase in inventory
($1,200)
+ increase in payables
$600
- decrease in accruals
Cash from operating
activities
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($100)
$900
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Constructing the Statement of
Cash Flows
• Investing activities
 Typically include purchasing Capital assets
 Examine the change in Gross Capital assets,
not Net
• Because the net value includes adjustment for
amortization
Example
• Amortization has already been included under Operating
activities
 For Belfry, cash from investing activities is
• Purchase of capital assets ($2,000)
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Constructing the Statement of
Cash Flows
• Financing activities
Example
 Deal with long-term debt and equity
 For Belfry, cash from financing activities is:
Increase in long-term debt
Sale of shares
Dividend paid
Cash from financing activities
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$1,200
800
2,000
(500)
$1,500
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Constructing the Statement of
Cash Flows
• The Equity Accounts
 Changes in equity are already shown
elsewhere
• Net Income is included in Cash flows from
operating activities
• Sale of shares and dividends are considered under
Cash flows from financing activities
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Constructing the Statement of
Cash Flows
• The Cash Account
Example
 Sum of cash flows from operating activities,
financing activities and investing activities
must equal the change in cash
 For Belfry, change in cash balance is:
Beginning cash balance
Net cash flow
Ending cash balance
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$1,000
400
$1,400
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Constructing the Statement of
Cash Flows—Example
Example
Belfry Company
Statement of Cash Flows
For the period ended 31/12/X2
CASH FROM OPERATING ACTIVITIES
Net income
Amortization
Net changes in current accounts
Cash from operating activities
CASH FROM INVESTING ACTIVITIES
Purchase of capital assets
CASH FROM FINANCING ACTIVITIES
Increase in long-term debt
Sale of shares
Dividend paid
Cash from financing activities
NET CASH FLOW
Beginning cash balance
Net cash flow
Ending cash balance
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While the firm was
profitable it still had to
borrow money and sell
shares to finance the
increase in capital
assets.
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Free Cash Flows
• Cash flows from operating activities
 Some may be used to maintain long-run competitive
position
• Replace worn-out capital assets
• Pay dividends
• Free cash flow (FCF) refers to cash generated
beyond these needs
 Free cash flow =
• Cash flow from operating activities
• Minus:
Capital expenditures
• Minus:
Dividends
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Income Taxes
• Authorities and Tax Bases
 In Canada income tax is levied on both
individuals and corporations
 There are two taxing levels
 Federal
 Provincial
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Income Tax Formulas
(1) Total income – Tax deductions
= Taxable income
(2) Taxable income × Tax rates
= Total tax
(3) Total tax – Tax credits
Net tax payable
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=
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Income Tax Calculations
• Income taxes are calculated on taxable
income
• Income subject to tax less certain deductions
• Tax rates—combined rates levied by the
federal and provincial governments on taxable
income to determine tax payable
• Rate schedules for corporations and people are
very different as are rules for calculating
taxable income
• Tax credits may be available to reduce tax
otherwise payable
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Progressive Tax System, Marginal
and Average Rates
• Income tax system for individuals is
progressive
 Progressive tax system: higher tax rates on
higher income
 Tax bracket: range of income in which tax rate is
constant
 Marginal tax rate: rate that will be paid on next
dollar of income
 Average tax rate: total taxes paid as a
percentage of total income
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Combined Personal Tax
Brackets and Tax Rates, 2003
Table 2.4:
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Personal Taxes on Investment
Income
• Governments levy tax on various types of
personal income, including investment income
 interest from bonds
 dividends on shares
 capital gains from the sale of securities.
• Each type of investment income is taxed
differently.
 Interest income is taxed at person’s marginal rate
 Tax on dividends is reduced by dividend tax
credits
 Only 50% of capital gains to subject to tax
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Capital Gains and Losses
• Capital gain (loss) arises when long-term asset
that’s held for investment is sold for more
(less) than was paid for it
• Capital gains receive more favourable tax
treatment than ordinary income in order to
encourage investment
 Currently, only 50% of a capital gain is subject to
tax
 Capital losses can be used to offset capital gains
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Capital Gains and Losses
• Taxable capital gain:






Proceeds on sale of the asset
Less the cost of the asset
Less the expenses to sell the asset
Equals the capital gain
Less the exempt portion – 50%
Equals the taxable capital gain
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$
$
$
$
$
$
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Example
Tax on Capital Gains—Example
Q. During the last tax year, Helen Zhou sold an investment
property for $80,000 that she had purchased three years
earlier for $53,000. She also sold some Nortel shares for
$4,000 for which she had paid $12,000 two years before.
What is her taxable capital gain?
A.
Gain on investment property
$27,000
Loss on shares
(8,000)
Net capital gain
$19,000
Taxable capital gain (50%)
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$9,500
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Tax on Dividends
• Dividends received from Canadian
corporations also receive beneficial tax
treatment
• Individual investors who receive such
dividends are entitled to dividend tax
credits, which reduce their effective tax
rates on dividend income
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Taxes on Interest,
Dividend, and Capital Gains
Income, 2003
Table 2.5:
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Tax Rates and Investment
Decisions
• Investors need to consider the different
tax treatments in making investment
decisions.
 It is after-tax, not before-tax, income that
counts.
 Corporations allow for these different tax
treatments when considering financing
methods and distributions to their investors
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Corporate Taxes
• A corporation is liable for Canadian
corporation taxes if it
 was incorporated in Canada
 is managed from Canada
 or operates in Canada.
• A corporation must file both federal and
provincial tax returns
• Income taxes on corporate profits can
significantly reduce a corporation’s earnings
and cash flow.
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How Much Tax Will A Corporation
Pay?
• Total income is business’s revenue
• Deductions are Cost of goods sold and
expenses required to run the company
• A company’s Earnings before tax (EBT)
represent corporation’s taxable income
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How Much Tax Will A Corporation
Pay?
• Adjustments to Corporate Income
 Dividends Paid to Corporations
• Dividends received from another corporation are
deductible by the receiving corporation
 Tax Loss Carry Back and Carry Forward
• Business losses can be carried backward or
forward in time to offset taxes
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How Much Tax Will A Corporation
Pay?
• Corporate tax rates do not rise
consistently as taxable income rises
 Corporations generating high incomes pay a
constant rate on all their income
 Rate reductions for small private
corporations and manufacturing businesses
• Some corporate tax credits allowed
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Table 2.6: Combined
Corporate Tax
Rates on Private Corporations with
Active Business Income
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Corporate Taxes—Example
Q: Using the corporate tax rates in Table 2.6, calculate the tax
liability for a private corporation (CCPC) making EBT of
$330,000.
Example
A: Applying the corporate tax table results in the following tax
liability:
$225,000 x 0.19
42,750
$75,000 x 0.23
17,250
$20,000 x 0.30
6,000
$10,000 x 0.41
4,100
Total
70,100
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Table 2.7: Combined Corporate Tax Rates on
Business Income (Corporations Other Than
CCPCs), 2003
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Effect of Corporate Taxes
• Taxes affect most financial transactions:
 Dividend policy: capital gains versus
dividend policy
 Capital budgeting: return on investment
 Leasing: motivated by tax effects
 Capital structure policy: tax advantage of
debt financing
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Corporate Taxes and Financing
• Taxes and Financing
 The corporate tax system favors debt
financing over share financing
 Interest payments made to debt investors
are tax deductible
• Dividend payments to equity investors are not tax
deductible
 If two companies generated the same EBT,
but one firm was financed entirely with debt,
firm with debt financing would have lower tax
liability
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