Chapter 2 - Financial background: A Review of Accounting, Financial Statements and Taxes

The Nature of Financial Statements Numerical representations of a firm’s activities for an accounting period A picture of activities within the firm and between the firm and the outside But can be counterintuitive

Accounts Receivable Most sales are on credit Seller receives a promise of later payment, rather than immediate cash The seller records an account receivable as an asset Net income may not = cash flow

Depreciation Proration of an asset’s cost over its service life Can be straight lined or accelerated Cost recorded on the income statement does not = cash spent

The Nature of Financial Statements 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 recorded Double entry system Accounting periods and closing the books Implications Stocks and flows

Table 2-1 A Typical Income Statement

The Income Statement Sales Cost and Expenses Costs of Goods Sold Depreciation Gross margin Earnings before interest and taxes (EBIT)

Earnings Before Tax, and Tax Net Income Terminology: The Income Statement Earnings Before Tax, and Tax Net Income Terminology: Income = profit = earnings Profit before tax (PBT) Profit after tax (PAT) Earnings before tax (EBT) Earnings after tax (Net Income)

Retained Earnings (RE) Also called net income Paid out as dividends or retained in business Retained Earnings (RE) Each year earnings not paid as dividends become an addition to equity Retained earnings account is cumulative earnings not paid out as dividends

Lists everything a company owns and owes at a moment in time The Balance Sheet Lists everything a company owns and owes at a moment in time All sources and uses of money must be equal A firm’s money sources include creditors and owners Borrowing creates a liability for repayment

Assets and liabilities are arranged in order of decreasing liquidity The Balance Sheet Two equal sides Assets = liabilities + equity Assets and liabilities are arranged in order of decreasing liquidity Liquidity – ease with which an asset becomes or a liability requires cash

Table 2-2 A Conventional Balance Sheet Format

Assets Cash Checking balances plus currency Marketable securities are liquid investments held instead of cash Short-term, modest return, low risk Accounts Receivable Uncollected credit sales Bad Debt Reserve: some credit sales will never be paid Write Off: Remove bad debt from gross and reserve leaving net unchanged

Concept Connection Example 2-1 Writing Off a Large Uncollectable Receivable Gross accounts receivable $5,650 Bad-debt reserve (290) Net accounts receivable $5,360 Need to Write Off $435,000 Reserve 290,000 Expense $145,000 Reestablish Reserve (5%) 260,750 Profit Reduction $405,750

Assets Inventory - product held for sale in the normal course of business Work-In-Process Inventories (WIP) Value added as inventory moves through production The Inventory Reserve Some inventory is unusable - balances reported net of reserve Writing Off Bad Inventory Missing, damaged, or obsolete items removed from gross and reserve leaving net unchanged

Assets Overstatements If assets are overstated, firm’s value is less than total shown on balance sheet Current Assets Become cash within a year Include cash, accounts receivable and inventory Fixed Assets Long lived, depreciable, also called property, plant and equipment (PPE) Useful life of at least a year

Financial Statement Representation Assets Depreciation Spreads asset’s cost over its estimated useful life Financial Statement Representation Appears as an expense or cost Accumulated depreciation appears on balance sheet reflecting a wearing out of the asset

Table 2-3 Fixed Asset Depreciation

Disposing of a Used Asset The Life Estimate Assets Disposing of a Used Asset The Life Estimate Tax Depreciation and Tax Books Government allows different depreciation schedules for tax purposes and financial reporting purposes

Concept Connection Example 2-2 Selling a Fixed Asset Accounting Cash Flow Revenue $4,000 $4,000 Cost (NBV) 2,500 Profit contribution: EBT $1,500 Tax (30%) (450) (450) Contribution: net income $1,050 Cash flow $3,550

Liabilities What a company owes to outsiders Accounts Payable Arise when a firm buys from vendors on credit Terms of Sale Specify when payment is due on credit sales and the early payment discount Understated Payables

Liabilities Accruals Current Liabilities Recognize expenses and liabilities associated with incomplete transactions Payroll Accrual Current Liabilities Require cash within one year Payable and accruals are classified as current

Figure 2-1 A Payroll Accrual

Working Capital Total current assets = gross working capital Net Working Capital = Current Assets ─ Current Liabilities

Fixed Financial Charges Long Term Liabilities Long Term Debt The most significant non-current liability Leverage A business partially financed with debt is leveraged Fixed Financial Charges Interest must be paid regardless of profitability

Concept Connection Example 2-3 Leverage A business is financed with equity of $100,000 Net Income = $15,000 Return on equity = 15% ($15,000/$100,000) Calculate return on equity if $50,000 borrowed at an after tax interest rate of 10%

Concept Connection Example 2-3 Leverage Borrowing levers return on equity up from 15% to 20%.

Equity Common Stock Preferred Stock Retained Earnings Capital Has mix of characteristics of both debt and equity Retained Earnings All previous earnings not paid out as dividends Capital The sum of long-term debt and equity Total Liabilities and Equity Sum of the right-hand side of the balance sheet Must equal total assets

Equity Accounts Illustration Three Separate Accounts Direct Investment by owners paying for stock Par value and paid in excess accounts Retained Earnings Illustration: 20,000 shares of $2 par sold for $8 Firm Earns $70,000 Pays dividends of $15,000 Common Stock ($2 x 20,000) $ 40,000 Paid in Excess ($6 x 20,000) 120,000 Retained Earnings ($70,000 - $15,000) 55,000 Total Equity $215,000

Net Income and Retained Earnings Beginning Equity + Net Income – Dividends + New Stock Sold = Ending Equity

Taxing Authorities and Tax Bases The Tax Environment Taxing Authorities and Tax Bases Income tax Wealth tax Consumption tax Sales tax

Income Taxes—The Total Effective Tax Rate (TETR) Total effective tax rate (TETR) is the combined state and federal rate State tax is deductible from income when calculating federal tax TETR = Tf + Ts (1 – Tf) where Tf = federal tax rate Ts = state tax rate

Progressive Tax Systems, Marginal and Average Rates Brackets Marginal and average tax rates

Capital Gains and Losses Two major types of income Ordinary income Capital gains or loss and dividends

The Tax Treatment of Capital Gains and Losses Capital gains historically taxed at lower rates Holding period must be > 1 year for favorable tax treatment

Income Tax Calculations Income taxes are paid by households and corporations according to the same basic principles Tax is levied on a base of taxable income But rate schedules for corporations and households are very different as are the rules for calculating taxable income

Table 2-4 Personal Tax Schedules - 2012

Personal Taxes Taxable Income Wages, profits, interest and dividends are basic taxable income Deductions are personal expenditures that can be subtracted from income before calculating taxes Exemptions are fixed amounts per person that can be subtracted from income to arrive at taxable income

Concept Connection Example 2-4 Calculating Personal Taxes The Harris family had the following income in 2012: Salaries: Joe $55,000 Sue 52,000 Interest on savings acct 2,000 Interest on IBM bonds 800 Interest on Boston Bonds 1,200 Dividends - Gen Motors 600

Concept Connection Example 2-4 Calculating Personal Taxes In 2012 the Harris family: Sold property for $50,000, paid $53,000 years earlier Sold stock for $14,000, paid $12,000 years earlier. Paid $12,000 interest on home mortgage Paid $1,800 in real estate taxes. Had $3,500 withheld from pay for state income tax Contributed $1,200 to charity. Have two children Exemption rate is $3,800 per person. Calculate taxable income and tax liability. What are marginal and average tax rates?

Concept Connection Example 2-4 Calculating Personal Taxes Ordinary income: Deductions: Salaries $107,000 Mortgage interest $12,000 Interest 2,800 Taxes 5,300 $109,800 Charity 1,200 $18,500 Net capital gain or loss: Loss on property ($3,000) Exemptions: Gain on stock 2,000 $3,800 x 4 = $15,200 Net capital loss ($1,000) Total Income $108,800 Taxable Income $75,100 (excludes dividends)

Concept Connection Example 2-4 Calculating Personal Taxes Use the married filing jointly schedule as follows: 10% of the entire first bracket $17,400 x .10 = $1,740 15% of the amount in the second bracket ($70,700- $17,400) x .15 = 7,995 25% of the amount in the third bracket ($75,100 - $70,700) x .25 = 1,000 Tax Liability $10,835 Tax on dividends $600 x .15 = 90 Total tax liability $10,925 Average tax rate: $10,925/$75,700 = 14.4% Marginal tax rate = bracket rate = 25% (15% if dividends or capital gains)

Tax Rates and Investment Decisions Personal Taxes Tax Rates and Investment Decisions Comparing municipal (muni) and corporate bonds Interest on muni’s not subject to federal taxes At same rate muni’s return is higher after taxes If the rates differ, restate corporate to an after tax yield Multiply by one minus investor’s marginal tax rate (1 – marginal tax rate)

Concept Connection Example 2-5 Comparing Taxable and Tax Exempt Returns The Harris family (25% bracket) has a choice between an IBM bond paying 11% and a Boston bond paying 9%. Solution: IBM after tax = 11% x (1 - .25) = 8.25% < Boston = 9% Therefore prefer the Boston bond if risks are similar. If marginal tax rate is 15% 11% x (1 - .15) = 9.35% then prefer IBM High bracket taxpayers tend to be more interested in tax exempt bonds than those with lower incomes.

Corporate Taxes Similar in principle to personal taxes: total income is revenue Earnings Before Tax (EBT) is taxable income Corporate tax rates do not consistently rise as taxable income rises

Table 2-5 Corporate Income Tax Schedule 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.

Concept Connection Example 2-6 Corporate Income Taxes Calculate the tax liability for corporations with the following EBTs: a. $280,000 b. $500,000 c. $16,000,000 d. $23,000,000 SOLUTION: a. Applying the corporate tax table to $280,000 yields the following: $ 50,000 × .15 = $ 7,500 $ 25,000 × .25 = 6,250 $ 25,000 × 34 = 8,500 $180,000 × .39 = $ 70,200 $ 92,450 b. Between $335,000 and $10 million the overall tax rate is 34% so the tax on $500,000 is $500,000 × 34 = $170; 000

Concept Connection Example 2-6 Corporate Income Taxes c. We don’t have to go through the calculations in the bottom brackets because we know that the system recovers those benefits to an overall 34% up to $10 million. $10,000,000 × .34 = $3,400,000 $ 5,000,000 × .35 = $1,750,000 $ 1,000,000 × .38 = $ 380,000 $5,530,000 d. Over $18,333,333, the tax is a flat 35% of all income starting from nothing, so the tax on $23,000,000 is $23,000,000 × .35 = $8,050,000

Corporate Taxes Taxes and Financing The tax system favors debt financing Result: A debt-financed firm pays less tax than an identical equity financed company But the availability of debt is limited because it makes the borrowing company risky

Corporate Taxes

Dividends Paid to Corporations Corporate Taxes Dividends Paid to Corporations Dividends paid to another corporation are partially tax exempt

Figure 2-2 Multiple Taxation

Figure 2-3 Tax Loss Carry Back and Forward