INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth • W. Sean Cleary
Prepared by
Ken Hartviksen
CHAPTER 3
Financial Statements
Lecture Agenda
•
•
•
•
•
•
•
Learning Objectives
Important Terms
Accounting Principles
Organizing a Firm’s Transactions
Preparing Accounting Statements
The Canadian Tax System
Summary and Conclusions
– Concept Review Questions
CHAPTER 3 – Financial Statements
3-3
Learning Objectives
1.
2.
3.
4.
5.
6.
7.
The importance of preparing financial statements in
accordance with a given set of guidelines or principles, and
what the most important principles are
The fact that preparing accounting statements involves the
use of judgement
How the basic financial statements for a company are
constructed
The important information that can be found on a company’s
balance sheet, income statement and cash flow statement
Why accounting income differs from income for tax purposes
How the capital cost allowance (CCA) system works
How different forms of investment income are taxed for
corporations and for individuals.
CHAPTER 3 – Financial Statements
3-4
Important Chapter Terms
•
•
•
•
•
•
•
•
•
•
Amortization
Balance sheet
Capital gain
Capital loss
Cash flow from
operations
Cash flow statement
CCA recapture
Current assets
Depreciation
Free cash flow
• Generally accepted
accounting principles
(GAAP)
• Half-year rule
• Income statement
• Liquidity
• Operating loss
• Terminal loss
• Traditional cash flow
• Undepreciated capital cost
(UCC)
CHAPTER 3 – Financial Statements
3-5
Importance of Understanding Accounting
• Accounting is an organized way of summarizing
the activities of business.
• Internal and external users of accounting
information rely on accounting information to
make decisions.
• A strong understanding of accounting is
required of financial managers because they
use that information to make significant
management decisions that will affect the future
financial reports of the organization.
CHAPTER 3 – Financial Statements
3-6
Accounting Principles
• Generally Accepted Accounting Principals
(GAAP) are contained in the CICA
Handbook and have the force of law in
Canada.
• The Income Tax Act (ITA) requires use of
the CICA Handbook, except where
specifically, the Act requires other
treatment.
– This has led to the practice of Canadian
companies reporting to shareholders using CICA
GAAP, and preparing separate financial
statements for Canada Revenue Agency (CRA)
• Reporting of financial performance in a
consistent manner over time and between
firms enhances the usefulness of those
reports allowing comparative analysis.
CHAPTER 3 – Financial Statements
3-7
Accounting Principles
International Convergence
• Different countries have different accounting standards:
– Canada – (CICA) Canadian Institute of Chartered Accountants
Handbook
– United States – (FASB) Financial Accounting Standards Board
– Japan – (ASBJ) Accounting Standards Board of Japan
• Given the growing importance of international trade,
integration of product and financial markets, there is a
need for countries to move to a common set of
accounting standards.
– (IASB) London-based International Accounting Standards Board
has been working with FASB and other accounting boards from
numerous countries to work toward a common standard.
CHAPTER 3 – Financial Statements
3-8
Accounting Principles
Recent Accounting Scandals
• ENRON
– Bankruptcy of one of the largest U.S. firms because of
financial statement misrepresentation involving the
external auditor (Arthur Andersen), management, and
financial partners including Merrill Lynch, Citigroup,
CIBC and others
• Other accounting/investment scandals involving
WorldCom, Tyco, Bristol-Myers, Nortel and
others demonstrate that the ENRON issue was
not an isolated incident.
CHAPTER 3 – Financial Statements
3-9
Accounting Principles
Impact of Recent Accounting Scandals
• Investors base investment decisions and
estimate the value of stock using accounting
information.
• Recent accounting scandals where financial
statements were found either to misstate the
financial results, or later required revision has
shaken the confidence of investors in financial
markets.
• U.S. Congress in 2002 passed the SarbanesOxley Act (SOX) in an attempt to restore
investor confidence.
CHAPTER 3 – Financial Statements
3 - 10
Accounting Principles
Main Provisions Sarbanes-Oxley Act 2002
• Creation of the Public Company Accounting Oversight Board
– Register and inspect public accounting firms
– Establish audit standards
• Separation of the audit function from other services provided
by auditing firms
• Improve governance standards
– Separate board committees for finance and audit
– External auditors must report to the audit committee
– Audit committee independence (membership must be dominated by
external directors) and financial expertise
• Requires the annual report to indicate the state of the firm’s
internal controls and assess their effectiveness
• CEO and CFO must ‘certify’ that the firms financial statements
“fairly present in all material respects, the operations and
financial condition of the issuer”
CHAPTER 3 – Financial Statements
3 - 11
Organizing a Firm’s Transactions
Bookkeeping Versus Accounting
Bookkeeping
• is the mechanical act of managing and
recording transactions.
Accounting
• is the application of GAAP principles and
conventions to the bookkeeping data to
produce financial statements that fairly
represent the financial condition and operations
of the economic entity.
CHAPTER 3 – Financial Statements
3 - 12
Organizing a Firm’s Transactions
Accounting Conventions: The Basic Principles
The most basic principles of GAAP are:
1.
2.
3.
4.
5.
6.
The entity concept
The going concern principle
A period of analysis
A monetary value
The matching principle
Revenue recognition
CHAPTER 3 – Financial Statements
3 - 13
Organizing a Firm’s Transactions
Accounting Conventions: The Basic Principles
The most basic principles of GAAP are:
1.
The entity concept
•
2.
The going concern principle
•
3.
Historical costs are used because the objectivity inherent in arms-length
transactions
The matching principle
•
6.
Usually a fiscal year, although quarterly and monthly financial statements
are also produced
A monetary value
•
5.
The statements are prepared on the basis that the economic entity will
continue to operate into the future (hence liquidation values, for example,
are not relevant)
A period of analysis
•
4.
The accounting is for a specific economic entity
Expenses incurred must be matched to the revenue earned in the period of
analysis.
Revenue recognition
•
Revenue is recognized when it has been earned (even though the cash
may not yet have been received).
CHAPTER 3 – Financial Statements
3 - 14
Organizing a Firm’s Transactions
Accounting Conventions: The Basic Principles
The major conventions of GAAP are:
1.
2.
3.
4.
5.
Procedures
Standards
Consistency
Materiality
Disclosure
CHAPTER 3 – Financial Statements
3 - 15
Organizing a Firm’s Transactions
Accounting Conventions: The Basic Principles
The major conventions of GAAP are:
1. Procedures
•
Assets are on the left, liabilities and equities on the right-hand side
of the balance sheet
2. Standards
•
CICA Handbook
3. Consistency
•
The firm should consistently apply the same accounting principles
over time to ensure comparability of financial statements from prior
periods
4. Materiality
•
All significant information is disclosed
5. Disclosure
•
The financial statements should fully and fairly disclose the firm’s
financial position. Objectivity, consistency and conformity to GAAP
are all aspects of full disclosure
CHAPTER 3 – Financial Statements
3 - 16
Preparing Accounting Statements
The Balance Sheet
• The balance sheet is a financial ‘snapshot’ at
one point in time (usually on the last day of the
firm’s fiscal year)
• It is an ‘inventory’ of what the firm owns
(assets) and how those assets were financed
(liabilities and owners equity)
– Left-hand side lists assets
– Right-hand side list liabilities and owners equity
– Top to bottom items are listed from most liquid, to
least liquid
CHAPTER 3 – Financial Statements
3 - 17
Preparing Accounting Statements
The Balance Sheet – Basic Structure
Basic Balance Sheet Structure
ABC Corporation Limited
Balance Sheet
as at March 31, 200X
Cash
Marketable Securities
Accounts Receivable
Inventory
Net fixed assets
Total assets
5
10
10
25
100
150
Accrued wages and taxes
Accounts payable
Long-term debt
Common stock
Retained earnings
Total liabilities and owners equity
CHAPTER 3 – Financial Statements
5
5
20
40
80
150
3 - 18
Preparing Accounting Statements
The Income Statement
• Also known as the profit and loss statement
• Reports the income earned over a given period
of time
– Usually prepared to report on one fiscal year
– Can be prepared for a quarter of a year (3 months) or
even a month
• Reports expenses incurred in order to earn that
income (application of the matching principle)
• Shows sales, expenses and net profit for a given
period.
CHAPTER 3 – Financial Statements
3 - 19
Preparing Accounting Statements
The Income Statement – Basic Structure
Basic Income Statement Structure
ABC Corporation Limited
Income Statement
for the year ended March 31, 200X
Revenues
Cost of goods sold
Gross margin
Selling and administrative expenses
Earnings before Interest and Taxes
Interest expense
Earnings before tax
Income taxes
Net income
Dividends
Retained earnings
$6,700,000
4,020,000
2,680,000
1,500,000
1,180,000
450,000
730,000
233,600
$496,400
Variable
Costs
including
direct
materials
and direct
labour.
$100,000
$396,400
CHAPTER 3 – Financial Statements
3 - 20
Preparing Accounting Statements
The Income Statement – Basic Structure
Basic Income Statement Structure
ABC Corporation Limited
Income Statement
for the year ended March 31, 200X
Revenues
Cost of goods sold
Gross margin
Selling and administrative expenses
Earnings before Interest and Taxes
Interest expense
Earnings before tax
Income taxes
Net income
Dividends
Retained earnings
$6,700,000
4,020,000
2,680,000
1,500,000
1,180,000
450,000
730,000
233,600
$496,400
Fixed period
costs
including
salaries, rent
and
depreciation.
$100,000
$396,400
CHAPTER 3 – Financial Statements
3 - 21
Preparing Accounting Statements
The Income Statement – Basic Structure
Basic Income Statement Structure
ABC Corporation Limited
Income Statement
for the year ended March 31, 200X
Revenues
Cost of goods sold
Gross margin
Selling and administrative expenses
Earnings before Interest and Taxes
Interest expense
Earnings before tax
Income taxes
Net income
Dividends
Retained earnings
$6,700,000
4,020,000
2,680,000
1,500,000
1,180,000
450,000
730,000
233,600
$496,400
Financing
costs.
Interest
expense is
taxdeductible.
$100,000
$396,400
CHAPTER 3 – Financial Statements
3 - 22
Preparing Accounting Statements
The Income Statement – Basic Structure
Basic Income Statement Structure
ABC Corporation Limited
Income Statement
for the year ended March 31, 200X
Revenues
Cost of goods sold
Gross margin
Selling and administrative expenses
Earnings before Interest and Taxes
Interest expense
Earnings before tax
Income taxes
Net income
Dividends
Retained earnings
$6,700,000
4,020,000
2,680,000
1,500,000
1,180,000
450,000
730,000
233,600
$496,400
Profit after
tax may be
retained in
whole or in
part to be
reinvested in
the firm and
fuel the firm’s
growth.
$100,000
$396,400
CHAPTER 3 – Financial Statements
3 - 23
Preparing Accounting Statements
Changing Accounting Assumptions
• GAAP provides flexibility in the accounting treatment of
things such as:
– When to recognize revenue
– Capitalizing expenses as assets versus expensing expenditures
– Rates of accounting depreciation
• Managements may have strong pressures on them to
make the financial performance of the firm look as good
as possible (indeed often their personal compensation
may be affected by the accounting results)
– Consequently, managements may seek to change accounting
assumptions (within the limits allowed by GAAP) to suit their
needs and current circumstances facing the firm.
• Any change in application of GAAP must be disclosed in the audited
financial statements and could jeopardize the audit opinion offered
by the external auditors.
CHAPTER 3 – Financial Statements
3 - 24
Preparing Accounting Statements
Tax Statements
• In Canada businesses must report to CRA and remit income
taxes in accordance with the Income Tax Act.
– They are required to use CCA instead of depreciation
• Firms in Canada also tend to produce a separate set of
financial statements for shareholders, prepared in accordance
with GAAP.
• Because CCA is an ‘accelerated’ method of amortization, and
because assets are often replaced more frequently than they
are fully depreciated, then
– Actual income tax liability in accordance with ITA using CCA is usually
less than what is ‘estimated’ when reporting to shareholders.
– This ‘inter-temporal’ difference in tax liability is called ‘deferred taxes’
and capitalized on balance sheets when reporting to shareholders.
NOTE: deferred taxes DOES NOT mean that the firm hasn’t paid its full tax
liability to the government…it has.
CHAPTER 3 – Financial Statements
3 - 25
Preparing Accounting Statements
Accounting Income, Income for Tax and Economic Income
Accounting Income
– Net profit arrived at using GAAP and accounting depreciation
Income for Tax Purposes
– Net profit arrived at using GAAP and CCA in accordance with ITA
Economic Income
– The amount of funds a firm could withdraw from the firm at the end of an
accounting period, and leave the firm in the same income earning
position as it started the period
Generally:
Accounting Income > Tax Income > Economic Income
– Accounting income is usually greater than income for tax because the CCA
deductions are usually greater than accounting depreciation
– Economic income is less than income for tax because CCA and accounting
depreciation amounts are based on historical cost, and this understates the
amount of money the firm must retain, to replace its asset base at higher
replacement costs.
CHAPTER 3 – Financial Statements
3 - 26
Preparing Accounting Statements
Cash Flow Statements
•
•
•
•
Accounting profit may not reflect the cash flow reality
facing the firm.
The cash flow statement helps to provide a clearer
picture of where cash is coming from and where it is
going.
Analysts are very interested in the cash flow realities of
the firm because they realize that accounting profit is
often not available to manage to pay bills.
There are two ways to calculate the cash flow
statement:
1. Examine changes in the balance sheet accounts
2. Add by non-cash items to net income.
CHAPTER 3 – Financial Statements
3 - 27
The Cash Flow Statement
Changes in Balance Sheet Accounts
Sources of Cash
–
–
–
–
Any decrease in an asset
Any increase in a liability
Any increase in common stock (capital account)
Any increase in retained earnings
Uses of Cash
– Any increase in an asset
– Any decrease in a liability
CHAPTER 3 – Financial Statements
3 - 28
The Cash Flow Statement
Changes in Balance Sheet Accounts - Example
Example of Sources and Uses of Funds
Sources and Uses of Funds for Jim's Widgets
Sources of Funds
Increase in payables
Increase in accruals
Increase in loans
Increase in deferred taxes
Increase in owner's equity
Increased retained earnings
Total sources of cash
$5,000
1,000
10,000
1,500
44,000
2,000
63,500
Uses of Funds
Increase in receivables
Increase in inventory
Increase in prepaid expenses
Increase in machinery
Total uses of cash
Increase in cash
$5,000
2,000
3,500
28,000
38,500
25,000
CHAPTER 3 – Financial Statements
3 - 29
The Cash Flow Statement
Net Income Plus Non-cash Items
– Start with net income
– Add back the non-cash items in the income
statement (usually depreciation/amortization and
deferred income taxes)
CHAPTER 3 – Financial Statements
3 - 30
The Cash Flow Statement
Net Income Plus Non-cash Items - Example
Example of Cash Flow Statement
Cash Flow Statement for Jim's Widgets
Net income
Depreciation
Deferred income taxes
Traditional cash flow
Increase in receivables
Increase in prepaids
Increase in inventory
Increase in accruals
Increase in payables
Increase in net working capital
Cash flow from operations
Capital expenditures
Free cash flow
CHAPTER 3 – Financial Statements
$2,000
2,000
1,500
5,500
-5,000
-3,500
-2,000
1,000
5,000
-$4,500
1,000
-30,000
-29,000
3 - 31
The Canadian Tax System
• Federal and Provincial Governments in Canada tax
individuals and corporations based on income earned.
• Corporations pay income taxes, and then, out of after-tax
profit, distribute dividends to shareholders.
• Dividends received by shareholders are taxed again as
one form of personal investment income.
– Recognizing the double-taxation of dividends, dividends from
Canadian corporations are given some partial relief through the
‘dividend gross-up, tax credit system’
– Dividends received from non-Canadian companies do not qualify
for this special tax treatment.
CHAPTER 3 – Financial Statements
3 - 32
Corporate Income Taxation
• Corporate tax is paid at a ‘flat’ or fixed rate on ‘taxable income’
– Small businesses (income of $300,000 or less) face approximately (the
actual rate varies by province) a 20% tax on income (combined federal
and provincial)
• Companies are free to chose their own taxation year (fiscal
year) but once established cannot alter it without justification
and approval.
• Taxable income generally is income earned during the fiscal
year less expenses incurred in order to earn that income.
– The income statement shows that variable costs and period overhead
costs can be subtracted in determining EBIT
– For tax purposes, the ITA requires that the Capital Cost Allowance
system be used instead of accounting depreciation (amortization)
– Interest expense on debt borrowed to earn income is generally
deductible from earnings before the tax is determined.
CHAPTER 3 – Financial Statements
3 - 33
CCA
Capital Cost Allowance (CCA) is the
‘depreciation’ method used by taxpayers in
Canada when reporting business income to
CRA Canada Revenue Agency for tax purposes.
CHAPTER 3 – Financial Statements
3 - 34
Importance of CCA to Financial
Decisions
• Taxation issues must be explicitly addressed in
each financial decision you make.
• Since CCA affects the net income from a
business (and especially affects net cash flow),
knowledge of the CCA system is essential for all
business decision-makers.
CHAPTER 3 – Financial Statements
3 - 35
CCA gives rise to a ‘Tax Shield Benefit’ to
the Company
•
•
•
•
CCA is a non-cash deduction from income that would otherwise be
subject to income taxation.
As a result of the CCA deduction, taxable income is reduced.
This results in a savings in tax payable.
The tax shield benefits is equal to: T(CCA)
t = corporate tax rate
CCA = the dollar amount of CCA claimed
•
A firm with a 40% corporate tax rate and a $2,000 CCA deduction
will save $800 in taxes.
Tax Savings on CCA  Corporate Tax Rate  CCA
 40%  $2,000  $800
CHAPTER 3 – Financial Statements
3 - 36
Example:
Consider two firms that report $10,000 in earnings before CCA and taxes, face a 40% tax rate. One
firm has no CCA to claim, the other can claim $2,000 in CCA
Company A
Earnings Before CCA & Tax
CCA
Taxable Income
Taxes @ 40%
Net Income
Add back non-cash expense
Cash flow from Operations
$10,000
2,000
$ 8,000
3,200
$ 4,800
2,000
$ 6,800
Company B
$10,000
0
$ 10,000
4,000
$ 6,000
0
$ 6,000
Note that company A is better off by $800 because of the $2,000 non-cash
deduction of CCA. That is the amount of taxes saved.
If you look at net income, Company A appears to be worse off, however, that is
only an accounting illusion!!
CHAPTER 3 – Financial Statements
3 - 37
CCA vs. Accounting Depreciation
CCA
Accounting Depreciation
•
•
•
•
•
like assets are grouped into
pools or classes
the CCA rate used in each
asset class is setout in the
regulations to the Income
Tax Act and may or may not
reflect economic wastage
of the asset
no estimate of useful life or
of salvage value
as long as the firm remains
in existence, and assets
remain in the pool, residual
UCC values will remain in
the pool.
•
•
choose the method that will
best represent the
economic wastage of the
asset (declining balance,
sum-of-the-year’s digits,
straight-line, etc.)
individual assets are
depreciated
estimate of useful life and
salvage value is included
CHAPTER 3 – Financial Statements
3 - 38
CCA Over Time - A Simple Example
Assume you acquire a depreciable asset with a cost base of $100,000 and there are no
other assets in this pool. The CCA rate for the pool is 10%. Note you are allowed only
1/2 the regular CCA rate on the net additions to the pool in the year of acquisition.
Year
1
2
3
4
etc.
UCC of pool
$0
95,000
85,500
76,950
Addition CCA @ 10%
$100,000
$5,000
0
9,500
0
8,550
0
7,695
CHAPTER 3 – Financial Statements
3 - 39
CCA Tax Shield Over Time
(Assume a corporate Tax Rate ‘T’ of 40%)
Year
1
2
3
4
5
6
7
8
9
UCC of pool Addition CCA @ 10% T(CCA)
$0 $100,000
$5,000
$2,000
95,000
0
9,500
3,800
85,500
0
8,550
3,420
76,950
0
7,695
3,078
69,255
0
6,926
2,770
62,330
0
6,233
2,493
56,097
0
5,610
2,244
50,487
0
5,049
2,019
45,438
0
4,544
1,818
CHAPTER 3 – Financial Statements
3 - 40
Tax Shield Over Time
(A Graphical Representation)
T(CCA) at 10% on $100,000
4000
3500
3000
2500
Tax Shield 2000
1500
1000
500
0
Asymptotic
Curve
1
3
5
7
9 11 13 15 17 19
Year
CHAPTER 3 – Financial Statements
3 - 41
Observations
• In the foregoing you can now readily see:
 CCA a firm claims changes each and every year on a
‘declining balance’-like basis
 CCA provides the largest tax shields in the early years
of the asset’s life
 residual values remain in the pool long after the asset
was acquired…this means that the firm will never fully
recoup the original cost of the asset … as the firm’s
asset base ages, cash flows generated from CCA will
not enable the firm to replace the original asset.
CHAPTER 3 – Financial Statements
3 - 42
Disposition of Assets and CCA
Capital Gains
• A taxable capital gain would occur if the firm
sold a depreciable asset for greater than it’s
original cost.
Capital Gain = Original Cost Base - Salvage Value
CHAPTER 3 – Financial Statements
3 - 43
Disposition of Assets and CCA
Recapture of Depreciation
• If the salvage value of the asset exceeds the UCC of the
pool there is a recapture of depreciation
• recaptured depreciation is subject to tax
Recaptured Depreciation = UCCpool - Salvage Value
CHAPTER 3 – Financial Statements
3 - 44
Disposition of Assets and CCA
Terminal Loss
• When the last physical asset in the pool is sold and not
replaced, the pool will be closed out.
• If there is a positive balance remaining in the pool after
disposition, that balance is called a terminal loss and is
deductible from income in that year….it is a non-cash
deduction just like CCA.
CHAPTER 3 – Financial Statements
3 - 45
CRA Form for Capital Cost Allowance
An Example
Assume you want to calculate the CCA for Class
Six (10% CCA rate) given an opening UCC of
$91,874; additions to the class of $32,880 and
$25,000 as proceeds on disposals from the
class.
1
Class
number
6
2
Undepreciated
capital cost
(UCC) at the
start of the
year
3
Cost of
additions in
the year
4
Proceeds of
dispositions
in the year
91,874.00 32,880.00 25,000.00
5
6
7
UCC
Adjustments for Base amount
after additions
current year
for capital
and
additions (1/2
cost
dispositions
times (col. 3
allow ance
(col. 2 plus 3
minues 4)) If
(col. 5 minus
minus 4)
negative, enter
6)
99,754.00
3,940.00
8
Rate
%
95,814.00 10%
9
CCA
for the year
(col. 7 times
8 or an
adjusted
amount)
9,581.40
10
UCC at the
end of the
year (col. 5
minus 9)
90,172.60
CCA = $9,581
CHAPTER 3 – Financial Statements
3 - 46
Personal Income Taxation
• Canadians are taxed on their world-wide income
• The taxation year is the calendar year, starting on
January 1 and ending December 31
• The personal tax system is a ‘progressive’ one…as
taxable income increases, it is taxed at progressive
higher rates.
• Table 3 – 7 on the following slide illustrates the top
marginal tax rates in Canada on investment income
(interest, dividends and capital gains).
(Please see the following slide with Table 3 -7)
CHAPTER 3 – Financial Statements
3 - 47
The Canadian Tax System
Personal Income Taxation
Table 3-7 Top 2007 Personal Tax Rates
Taxable Income
Dividends
Eligible Non-eligible
Ordinary
Income
Capital
Gains
Federal Only
29.00%
14.50%
14.55%
19.58%
Alberta
British Columbia
39.00%
43.70%
19.50%
21.85%
17.45%
18.47%
25.21%
31.58%
Manitoba
46.40%
23.20%
23.83%
36.75%
New Brunswick*
46.95%
23.48%
23.18%
35.40%
Newfoundland and Labrador
48.64%
24.32%
32.52%
37.32%
Non-resident
42.92%
21.46%
21.53%
28.98%
Northwest Territories
43.05%
21.53%
18.25%
29.65%
Nova Scotia
48.25%
24.13%
28.35%
33.06%
Nunavut
40.50%
20.25%
22.24%
28.96%
Ontario
46.41%
23.20%
24.64%
31.34%
Prince Edward Island
47.37%
23.69%
24.44%
33.61%
Quebec
48.22%
24.11%
29.69%
36.35%
Saskatchewan
Yukon
44.00%
42.40%
22.00%
21.20%
20.35%
17.23%
30.83%
30.49%
*New Brunsw ick's 2007 budget revised the top combined rates.
CHAPTER 3 – Financial Statements
3 - 48
The Canadian Tax System
Personal Income Taxation of Investment Income
Investment income can be earned by investors
in three different forms:
– Interest
– Dividends
– Capital gains
CHAPTER 3 – Financial Statements
3 - 49
Taxation of Interest Income
• Interest income is taxed at the person’s personal
marginal tax rate (the same rate that employment and
business income is taxed at)
• We use the ‘marginal’ rate because when a person
invests, they are seeking to add to income in the
future…that added income will face the marginal tax
rate.
• All sources of interest must be claimed each calendar
year (both cash interest received, and interest income
that has accrued)
– Accrued interest is interest that has been earned, but not yet
received (for example, from compound interest Canada Savings
Bonds that have yet to be redeemed)
(Please see the following slide with Table 3 -6)
CHAPTER 3 – Financial Statements
3 - 50
Taxation of Interest Income
Ontario Tax Rates – Interest Income
Table 3-6 Ontario Taxable Income
Lower Limit
Upper
Limit
Basic Tax
Marginal Rate on
Rate on Dividend Capital
Excess
Income
Gains
$ - to
$8,148
$-
$8,149 to
$11,337 to
11,336
14,477
$510
16.00
28.10
3.33
5.63
8.00
14.05
$14,478 to
34,010
1,393
22.05
4.48
11.03
$34,011 to
35,595
5,700
25.15
8.36
12.58
$35,596 to
59,882
6,098
31.15
15.86
15.58
$59,883 to
68,020
13,664
32.98
16.86
16.49
$68,021 to
70,559
16,348
35.39
19.88
17.70
$70,560 to
71,190
17,246
39.41
22.59
19.70
$71,191 to
$115,740
115,739
and up
17,495
36,833
43.41
46.41
27.59
31.34
21.70
23.20
0.00%
0.00%
0.00%
Interest income is
taxed at the
investor’s personal
marginal rate.
All interest income,
whether received
in cash or accrued
is subject to tax in
each tax year.
Source: Ernst & Young w ebsite: <w w w .ey.com>.
CHAPTER 3 – Financial Statements
3 - 51
Taxation of Dividend Income
• Dividends from Canadian companies are taxed
using the ‘gross-up, tax credit system’
– Cash dividends are grossed up by 45% and this total
amount is included in taxable income
– A federal dividend tax credit of 18.97% and provincial
dividend tax credit of 6.5% (Ontario) is deducted from
taxes that would otherwise be payable.
– The effect of this system is to effectively reduce the
marginal tax rate applied to dividend income.
(Please see the following slide with Table 3 -6)
CHAPTER 3 – Financial Statements
3 - 52
Taxation of Dividend
Table 3-6 Ontario Taxable Income
Lower Limit
Upper
Limit
Basic Tax
Marginal Rate on
Rate on Dividend Capital
Excess
Income
Gains
$ - to
$8,148
$-
$8,149 to
$11,337 to
11,336
14,477
$510
16.00
28.10
3.33
5.63
8.00
14.05
$14,478 to
34,010
1,393
22.05
4.48
11.03
$34,011 to
35,595
5,700
25.15
8.36
12.58
$35,596 to
59,882
6,098
31.15
15.86
15.58
$59,883 to
68,020
13,664
32.98
16.86
16.49
$68,021 to
70,559
16,348
35.39
19.88
17.70
$70,560 to
71,190
17,246
39.41
22.59
19.70
$71,191 to
$115,740
115,739
and up
17,495
36,833
43.41
46.41
27.59
31.34
21.70
23.20
0.00%
0.00%
0.00%
The dividend
gross-up, tax credit
system makes
dividend income
the lowest taxed
investment income
in the lower tax
brackets.
Source: Ernst & Young w ebsite: <w w w .ey.com>.
CHAPTER 3 – Financial Statements
3 - 53
Taxation of Capital Gain Income
• Only realized capital gains are taxed
– This is a very important feature for high income earners who do
not need investment income to fund their everyday living
expenses…they can afford to wait to sell their investments
indefinitely…and indefinitely delay paying taxes on the capital
gains
• 50% of a realized capital gain is subject to tax at the
person’s marginal tax rate.
• Capital losses can only be used to offset taxable capital
gains.
(Please see the following slide with Table 3 -6)
CHAPTER 3 – Financial Statements
3 - 54
The Canadian Tax System
Personal Income Tax Rates – Capital Gains
Table 3-6 Ontario Taxable Income
Lower Limit
Upper
Limit
Basic Tax
Marginal Rate on
Rate on Dividend Capital
Excess
Income
Gains
$ - to
$8,148
$-
$8,149 to
$11,337 to
11,336
14,477
$510
16.00
28.10
3.33
5.63
8.00
14.05
$14,478 to
34,010
1,393
22.05
4.48
11.03
$34,011 to
35,595
5,700
25.15
8.36
12.58
$35,596 to
59,882
6,098
31.15
15.86
15.58
$59,883 to
68,020
13,664
32.98
16.86
16.49
$68,021 to
70,559
16,348
35.39
19.88
17.70
$70,560 to
71,190
17,246
39.41
22.59
19.70
$71,191 to
$115,740
115,739
and up
17,495
36,833
43.41
46.41
27.59
31.34
21.70
23.20
0.00%
0.00%
0.00%
Source: Ernst & Young w ebsite: <w w w .ey.com>.
CHAPTER 3 – Financial Statements
At the higher
marginal tax
brackets,
taxpayers will
prefer to receive
their investment
income in the form
of capital gains
because they are
taxed at a 23.2%
marginal rate.
Only ‘realized’
capital gains are
subject to tax.
3 - 55
Internet Links
•
•
•
•
•
Canada Revenue Agency – CCA Classes
Canada Revenue Agency – CCA Depreciable Property Described
Canada Revenue Agency – Tax Forms
Canada Revenue Agency – CCA Form 2006 and later years
About Capital Cost Allowance (Small Business Canada)
CHAPTER 3 – Financial Statements
3 - 56
Summary and Conclusions
In this chapter you have developed:
– A basic overview of accounting statements
– An understanding of the importance of generally
accepted accounting principles
– An understanding of the Canadian tax system
and the importance of tax considerations in
financial decision-making.
CHAPTER 3 – Financial Statements
3 - 57
Copyright
Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights
reserved. Reproduction or translation of this work beyond that
permitted by Access Copyright (the Canadian copyright licensing
agency) is unlawful. Requests for further information should be
addressed to the Permissions Department, John Wiley & Sons
Canada, Ltd. The purchaser may make back-up copies for his or her
own use only and not for distribution or resale. The author and the
publisher assume no responsibility for errors, omissions, or damages
caused by the use of these files or programs or from the use of the
information contained herein.
CHAPTER 3 – Financial Statements
3 - 58