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Financial Background: A Review of Accounting, Financial Statements, and Taxes Chapter 2
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Page 1: Chapter 2 lecture (PowerPoint) slides

Financial Background: A Review of Accounting, Financial Statements, and Taxes

Chapter 2

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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

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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 marketing or research

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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 leveraged firm pays

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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 known to be uncollectable, the balance in accounts receivable is reduced by that amount

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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

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.

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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25%Over $15,000

15%$5,000 - $15,000

10%0 - $5,000

Tax RateBracket

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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:

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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600Dividends from General Motors

1,200Interest on Boston bonds

800Interest on IBM bonds

2,000Interest on savings account

42,000 Sue

$45,000 Joe

Salaries

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Personal Taxes—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:

Their average tax rate is 16.3%, or $9,556 $58,700 while their marginal tax rate is 27%.

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$9,556Tax liability

$3,038

27% of the amount in the third bracket ($58,700 - $47,450) x .27

$5,318

15% of the amount in the second bracket ($47,450 - $12,000) x .15

$1,200

10% of the entire first bracket $12,000 x 0.10

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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 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:

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$92,450

Total

$70,200

$180,000 x .39

$8,500$25,000 x .34

$6,250$25,000 x .25

$7,500$50,000 x .15

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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