Chapter 2 Financial Background A Review of Accounting Financial Statements and Taxes The Nature of Financial Statements  Financial statements are numerical representations of a fi

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Chapter 2 Financial Background A Review of Accounting Financial Statements and Taxes The Nature of Financial Statements  Financial statements are numerical representations of a fi Powered By Docstoc
					Chapter 2

Financial Background: A
Review of Accounting, Financial
Statements, and Taxes
 The Nature of Financial
 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

The Nature of Financial
 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
     Depreciation—is the prorating of an asset‘s
      cost over its service life
     (also inventory or goods in process)
The Nature of Financial
 The Three Financial Statements
   Income statement
   Balance sheet
   Statement of cash flows
     Generated from the income statement and
      balance sheet

The Accounting System
 A firm‘s financial books are a collection of
  records in which money transactions are
   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

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

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
 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
  The Income Statement
 Sales (AKA: revenue)
   Total receipts from selling goods from normal business
     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
        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
   Interest—the price the firm pays for borrowing
   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                           9
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

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

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

The Balance Sheet—Assets
 Cash
   Money in checking accounts plus currency on
   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
     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     13

       accounts receivable is reduced by that amount
The Balance Sheet—Assets
 Inventory
   Product held for sale in the normal course of
     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
        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
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
   Can also mean firm is not managed

The Balance Sheet—Assets
 Current Assets
   Assets that can be expected to become
    cash within one year
   Include cash, accounts receivable and
   All the money received from normal
    business operations flows through these

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
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
  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
          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
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
        The solution is a month-end accrual representing the
         amount of the three days‘ wages                      20
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

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
    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
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
   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
The Balance Sheet—Equity
 Retained Earnings
   A company‘s profits can be paid to its
    owners (generally through dividends) or
     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

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

The Balance Sheet—Equity
 Preferred Stock
   A cross between debt and common equity, a
     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

 Taxing Authorities and Tax
 In the U.S. there are typically three
  taxing levels
   Federal
   State
   Local

 Taxing Authorities and Tax
 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
   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

 Income Taxes—The Total
 Effective Tax Rate
 Total effective tax rate (TETR) is the
  combined rate to which the taxpayer is
 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
   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%
 Progressive Tax Systems,
 Marginal and Average Rates
 A progressive tax system is characterized
  by higher tax rates on incrementally higher
   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
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.
                                      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.

Capital Gains and Losses
 Ordinary income includes wages,
  business profits, dividends and
   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                     32
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
   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
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

Personal Taxes
 In 2001 Congress passed the Economic
  Growth and Tax Relief Reconciliation Act of
   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                                       35
Table 2.4

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

Personal Taxes—Example
           Q: The Smith family had the following income in 2003:
                    Joe                          $45,000
                    Sue                            42,000
                Interest on savings account         2,000
                Interest on IBM bonds                 800

                Interest on Boston bonds            1,200
                Dividends from General                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?

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 -


              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.

 Personal Taxes—Example
          A: Their tax liability is as follows:

               10% of the entire first bracket
                 $12,000 x 0.10
               15% of the amount in the           second

                  ($47,450 - $12,000) x           .15             $5,318
               27% of the amount in the           third bracket
                  ($58,700 - $47,450) x           .27
               Tax liability

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

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)

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
Table 2.5

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:

               $50,000 x .15          $7,500
               $25,000 x .25          $6,250
               $25,000 x .34          $8,500
               $180,000 x .39         $70,20
                   Total              $92,45

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

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
   Business losses can be carried backward
    or forward in time to offset taxes

Description: Balance Sheet Form for a Church document sample