Chapter 2
Financial Background: A
Review of Accounting, Financial
Statements, and Taxes
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
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The Nature of Financial
Statements
 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
 (also inventory or goods in process)
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The Nature of Financial
Statements
 The Three Financial Statements
 Income statement
 Balance sheet
 Statement of cash flows
 Generated from the income statement and
balance sheet
4
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
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The Accounting System
 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
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The Accounting System
 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
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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 8
marketing or research
The Income Statement
 Gross Margin
 Represents sales revenue less cost of goods sold
 1st 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
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leveraged firm pays
The Income Statement
 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
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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
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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
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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
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known to be uncollectable, the balance in
accounts receivable is reduced by that amount
The Balance Sheet—Assets
 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
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The Balance Sheet—Assets
 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
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The Balance Sheet—Assets
 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
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The Balance Sheet—Assets
 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
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The Balance Sheet—Assets
 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
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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
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The Balance Sheet—Liabilities
 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
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The Balance Sheet—Liabilities
 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
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The Balance Sheet—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
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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
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The Balance Sheet—Equity
 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
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The Balance Sheet—Equity
 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
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The Balance Sheet—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
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Taxing Authorities and Tax
Bases
 In the U.S. there are typically three
taxing levels
 Federal
 State
 Local
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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
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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 = Tfederal tax rate + Tstate tax rate(1 – Tfederal 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%
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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
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Progressive Tax Systems, Marginal and
Average Rates--Example
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.
Bracket
Tax Rate
0 - $5,000
10%
$5,000 - $15,000
15%
Over $15,000
25%
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.
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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
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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
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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
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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
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Table 2.4
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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
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Personal Taxes—Example
Q: The Smith family had the following income in 2003:
Salaries
Joe
$45,000
Sue
42,000
Example
Interest on savings account
Interest on IBM bonds
Interest on Boston bonds
Dividends from General
Motors
2,000
800
1,200
600
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?
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Personal Taxes—Example
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.
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Personal Taxes—Example
A: Their tax liability is as follows:
Example
10% of the entire first bracket
$12,000 x 0.10
15% of the amount in the
bracket
($47,450 - $12,000) x
27% of the amount in the
($58,700 - $47,450) x
Tax liability
$1,200
second
.15
third bracket
.27
$5,318
$3,038
$9,556
Their average tax rate is 16.3%, or $9,556  $58,700 while their marginal tax rate
is 27%.
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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)
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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
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Table 2.5
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Corporate Taxes—Example
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:
$50,000 x .15
$7,500
$25,000 x .25
$6,250
$25,000 x .34
$8,500
$180,000 x .39
$70,20
0
$92,45
0
Total
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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
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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
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