Slides developed by: Pamela L. Hall, Western Washington University Financial Background: A Review of Accounting, Financial Statements, and Taxes Chapter

Slides developed by:Pamela L. Hall, Western Washington University

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

Chapter 2

2

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

3

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

4

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

5

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

6


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

7


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

8

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

9


Gross Margin Represents sales revenue less cost of goods sold

• 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

10


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

12

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

13

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

14


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

15


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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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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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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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

19

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

20


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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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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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

23

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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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

25


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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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

31

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

33

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

34

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

35

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

38

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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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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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

41

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)

42

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

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

46

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

Documents

Slides developed by: Pamela L. Hall, Western Washington University Financial Background: A Review of Accounting, Financial Statements, and Taxes Chapter