Financial Background: A Review of Accounting,

Financial Statements, and Taxes

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The Nature of Financial Statements

Three Financial Statements Income statement Balance sheet Statement of cash flows

Generated from the income statement and balance sheet

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The Accounting System

The Double Entry System In double entry accounting every entry has two

sides that must balance

Example: Borrowing $1,000 to buy a machine, involves increasing an asset account by $1,000 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 Can be used to make predictions

Stocks and Flows Income statement reflects money flows over a period of time Balance sheet represents stocks of money at a point in time

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A Typical Income StatementSales (Revenue) $1,000

Cost of Goods Sold 600

Gross Margin $ 400

Expenses 230

Earnings bef. interest & tax $ 170

Interest expense 20

Earnings before tax $ 150

Tax 50

Earnings after tax $ 100

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The Income Statement

Sales or Revenue Total receipts from selling goods from

normal business operations

Cost and Expense Represent money spent to do business

Costs of Goods Sold — money spent on items closely related to the production of the product or service being sold

Expense — spending on items that aren’t closely related to production (such as marketing)

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The Income Statement

Gross Margin (GM) Represents sales revenue less cost of goods sold

Fundamental measure of profitability

Interest Price the firm pays for borrowing money

Earnings Before Interest and Taxes (EBIT) Profit before considering financing charges

Also called “operating profit” Helps judge the strength of business operations without

onsidering the interest expense a firm with debt pays

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The Income Statement

Earnings Before Tax (EBT) and Tax Earnings before taxes (EBT) represent gross margin

less all expenses except taxes Tax refers to income taxes on EBT

Net Income (also Earnings After Tax or EAT) 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

Has two sides Assets = liabilities + equity

Also called a Statement of Financial Position

Assets and liabilities are arranged in order of decreasing liquidity Liquidity – ease with which an asset becomes cash

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A Conventional Balance Sheet Format

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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

Accounts ReceivableRepresent credit sales that have not yet been paidBad Debt Reserve: some credit sales will never be paidWrite Off: When a receivable is uncollectible, it is taken out of the balance. A like amount is subtracted from the bad debt reserve leaving the net unchanged

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Assets

Inventory Product held for sale in the normal course of

business Work-In-Process Inventories

As inventory moves through the production process, value is added increasing the balance

The Inventory Reserve Some inventory is usually unusable - inventory

balances are reported net of a reserve Writing Off Bad Inventory

Missing, damaged, or obsolete items are removed and a like subtraction made from the reserve

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Assets

Overstatements If assets (usually receivables and inventory) are

overstated – firm’s value is less than the amount shown on the balance sheet Can mean a firm is not managed efficiently

Current Assets Become cash within one year Include cash, accounts receivable and inventory Money received from normal business operations

flows through these accounts

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Assets

Fixed Assets Long lived – not physically fixed Sometimes called property, plant and equipment (PPE) Useful life of at least a year

Depreciation Spreads asset’s cost over its estimated useful life Matching principle – an asset’s cost should be recognized over a

period matching its service life

Financial Statement Representation Depreciation on the income statement reflects an asset’s cost, the

same depreciation also appears on the balance sheet reflecting a wearing out

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Assets

Disposing of a Used Asset An asset may be sold for more or less than the net asset value on

the books

The Life Estimate An asset remaining in use beyond its depreciation life is “fully

depreciated”

Tax Depreciation and Tax Books Government allows different depreciation schedules for tax

purposes and financial reporting purposes Tax books – financial records generated using tax rules Financial books – regular financial statements

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Liabilities

What a company owes to outsiders

Accounts Payable Arise when a firm buys from vendors on credit

Trade Credit – vendor delivers product without demanding immediate payment

Terms of Sale Specify when payment is due on credit

sales and the early payment discount 2/10, n/30 - payment in 30 days with a 2% discount

if paid within 10 days

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Liabilities

Accruals Represent incomplete transactions Recognizes expenses and liabilities associated with

incomplete transactions Common example is a Payroll Accrual

Current Liabilities Require cash within one year Includes payables, accruals, notes payable, short-term

loans, long-term debt due within the year

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Working Capital

Total current assets are gross working capital – required to run a business day to day

Net working capital is the difference between current assets and current liabilities Can’t run a business without it

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Liabilities

Long-Term Debt The most significant non-current liability Consists of bonds and long-term loans

Leverage A business partially financed with debt is leveraged

In good times leverage enhances return on investment But in bad times it makes return on investment worse

Fixed Financial Charges The most significant concern about borrowed money is fixed

interest charges Interest Must be paid regardless of profitability

Can lead to bankruptcy in bad times I.e., too much debt can cause business failure

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Leverage

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Equity

Funds supplied to a business by owners Direct investment – price paid for stock or

entrepreneur’s contribution Retained earnings – profits kept in the business rather

than paid to owners

Balance sheet Representation of Equity Money paid for stock

Common stock account carries a par value per share Par is an arbitrary number

Excess or surplus represents amounts paid for the stock in excess of (over) par value

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Equity

Retained Earnings Profits that have not been distributed to

owners As dividends if firm is a corporation

Do not represent a reserve of cash Adds up all the earnings ever retained by the

firm

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Example: Equity Accounts

A firm is started by selling 20,000 shares of $2 par value stock at $8 per share. Subsequently the company earns $70,000 out of which it pays dividends of $15,000

Common stock ($2 x 20,000 =) $ 40,000Paid in excess ($6 x 20,000=) 120,000Retained earnings

($70,000 - $15,000 =) 55,000Total equity $215,000

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The Relationship Between Net Income and Retained Earnings

If no dividends are paid and no new stock is sold Beginning equity + net income = ending equity

If dividends are paid Beginning equity + net income – dividends

= ending equity

If new stock is sold Beginning equity + net income – dividends + stock

= ending equity

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Equity

Preferred Stock Equity that has some of the characteristics of

debt Although a “hybrid,” it is classified as equity

Total Capital The sum of long-term debt and equity

Total Liabilities and Equity Sum of the right-hand side of the balance sheet Must always equal total assets

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The Tax Environment

Taxing Authorities and Tax Bases Taxes are imposed by various government

authorities Federal, state and local

A tax base is the item that is taxed Income, wealth or consumption

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Taxing Authorities and Tax Bases

Income Tax Individuals pay a fraction of income in a

certain time period to the taxing authority

Wealth Tax Based on the value of certain types of assets, usually

real estate Consumption Tax

Based on the amount of certain goods used, usually sales taxes

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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 when calculating

federal tax

TETR = Tfederal tax rate + Tstate tax rate(1 – Tfederal tax rate)

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% Less than the sum of the two rates

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Progressive Tax Systems, Marginal and Average Rates

Progressive tax system - higher tax rates on incrementally higher income

Tax bracket - range of income in which the tax rate is constant

Marginal tax rate - rate paid on the next dollar of income a taxpayer earns

Average tax rate - the percentage of total income paid in taxes

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Progressive Tax Systems, Marginal and Average Rates

Q: Given the following tax brackets, calculate the tax on an income of $11,000. Also calculate the taxpayer’s marginal and average rates.

A: Since the taxpayer earned more than $5,000 (but less than $15,000) she will be taxed at two rates. The first $5,000 is taxed at 10%: $5,000 x .10 = $ 500 The remaining $6,000 is taxed at 15% $6,000 x .15 = $ 900 Thus, her total tax is $1,400

Her marginal tax rate is 15%, since she would pay that on her next dollar of income, and her average tax rate is $1,400 $11,000 = 12.7%

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15%$5,000 - $15,000

10%0 - $5,000

Tax RateBracket

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Capital Gains and Losses

Two major types of income

Ordinary income results from normal money-making activity Wages, business profits, dividends and interest Negative profits are an ordinary loss

Capital gains or loss arises when something is purchased, held for a while and sold at a different price

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The Tax Treatment of Capital Gains and Losses

Historically capital gains have been taxed at lower rates than ordinary income

If holding period < 1 year then short-term capital gain is not eligible for favorable tax treatment

Gains on assets held for > 1 year qualify for long-term treatment Tax rate capped at 15% for individuals Capital losses offset capital gains Corporations do not receive favorable rates on capital gains

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Personal Taxes Taxes on people (households) 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

Between 2001 and 2003 Congress lowered personal tax rates to stimulate the economy Before 2001 the top rate was 39.6% Since 2003 it is 35%

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Personal Tax Schedules - 2006 Table 2.4

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Personal Taxes

Tax Rates and Investment Decisions When comparing municipal bond investments to

corporate bonds, an adjustment must be made

Interest on muni’s are not taxed If a muni and corporate bond, of similar risk, are paying the

same rate, the muni’s return is higher after taxes If the rates differ, the corporate bond must be adjusted to an

after tax yield by multiplying by

(1 – marginal tax rate)

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Example 2.2 - Comparing Corporate and Municipal Bonds

The Smith family has the following choiceAT&T 11%Boston 9%

State AT&T after tax at marginal rate11% (1 - .25) = 8.25%Boston bond is better

If marginal rate is 15%, AT&T is better: 11% (1 - .15) = 9.35%

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Corporate Taxes

Similar in principle to personal taxes Total income is business revenue Deductions are the charges and expenditures required to run the

company Exemptions are not allowed

Earnings Before Tax (EBT) is 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 Corporate tax tables are constructed so that firms with high

incomes pay a constant rate on all of their income

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Corporate Income Tax ScheduleTable 2.5

The rate increases from 34% to 39% and 35% to 38% recover the benefit of lower rates on earlier income. So a corporation earning more than

$18,333,333 pays 35% on all of its income from the first dollar.

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Corporate TaxesExample 2.3

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 tax system favors debt over equity financing

Interest payments made to debt investors are tax deductible to the paying company

Dividend payments to equity investors are not deductible

Result: A debt financed firm pays less tax than an otherwise identical equity financed company

But the availability of debt is limited because it makes the borrowing company risky

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Taxes and Financing

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Corporate Taxes

Dividends Paid to Corporations Dividends paid to another corporation are

partially tax exempt The percentage exempted depends on the amount

of stock owned by the company Avoids more than double taxation of corporate

earnings

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Corporate Taxes

Tax Loss Carry Back and Carry Forward Business losses can be carried backward or

forward in time to offset taxes that might otherwise be excessive