Chapter 3 Financial Statements

Chapter 3 Outline 3.1 Accounting Principles Generally accepted accounting principles Auditors Accounting conventions Measuring costs and value Recognition principles Managing financial statements The effect of recent accounting scandals 3.2 Financial Statements The balance sheet The income statement The statement of cash flows 3.3 The Tax System Interest and dividends received Depreciation Capital gains Tax rates 2

 Corporations are distinct legal entities and are taxed as such.  Corporations file income tax returns with the Internal Revenue Service (IRS) that are determined in much the same way as corporations prepare their income statements for investors. 3.3 The Tax System 3

 Interest is fully taxable when received and fully deductible when paid.  Dividends are not tax deductible when paid; they are paid out of after-tax income. Tax issues: Interests and dividends 4

 For tax purposes, the government requires a specific form of depreciation. In the United States, this method is the Modified Accelerated Cost Recovery System (MACRS), which is based on the following assumptions:  Using a 200% declining balance method (that is, the annual rate is 200% of what the straight-line rate would be for the same asset life)  Ignoring salvage value for purposes of depreciation  Employing the half-year convention in the first year, which means that only one-half of the first year’s depreciation is actually allowed the first year, resulting in an extra year of depreciation  Assigning prescribed lives, based on the type of asset. That is, an asset may be a 3-year MACRS asset or a 5-year MACRS asset (there is no 4-year MACRS asset). The taxpayer must look up the asset in the tax code to determine its MACRS life. Depreciation for tax purposes 5

MACRS 6 Property ClassPersonal Property (all property except real-estate) 3-year property Special handling devices for food and beverage manufacture. Special tools for the manufacture of finished plastic products, fabricated metal products, and motor vehicles Property with ADR class life of 4 years or less 5-year property Information Systems; Computers / Peripherals Aircraft and parts (of non-air-transport companies) Computers Petroleum drilling equipment Property with ADR class life of more than 4 years and less than 10 years Certain geothermal, solar, and wind energy properties. 7-year property All other property not assigned to another class Office furniture, fixtures, and equipment Property with ADR class life of more than 10 years and less than 16 years 10-year property Assets used in petroleum refining and certain food products Vessels and water transportation equipment Property with ADR class life of 16 years or more and less than 20 years 15-year property Telephone distribution plants Municipal sewage treatment plants Property with ADR class life of 20 years or more and less than 25 years 20-year property Municipal sewers Property with ADR class life of 25 years or more 27.5-year propertyResidential rental property (does not include hotels and motels) 39-year propertyNon-residential real property Source: U.S. Internal Revenue Code

MACRS 7 MACRS rates for different classes Recovery year3-Year5-Year7-Year10-Year * Source: U.S. Internal Revenue Code

YearRate Depreciation expense Depreciation if straight- line, no salvage value %$2, %3,2002, %1,9202, %1,1522, %1,1522, % Total$10,000 MACRS example: $10,000 cost, 5 year asset

Deferred taxes Deferred tax assets Deferred tax liability 9  Tax benefits company expects to receive in the future  e.g., net operating loss carryover  Tax expected to be paid in the future.  e.g., MACRS for tax purposes but SL for financial reporting

 Capital gain - a taxable gain incurred when an asset is sold at a price greater than its original cost.  Capital loss - a tax deductible loss generated when a non-depreciable asset is sold at a price lower than its original cost. Capital Gains 10

Suppose you sell an asset for $8,000 that has a book value of $5,760. And suppose you paid $20,000 for this asset three years ago. If the tax rate on ordinary income is 25% and the tax on capital gains is 20%, what is the tax on this sale? Capital gains and taxes 11

Sale price$8,000 Book value5,760 Gain$2,240 Tax rate25% Tax$560 Capital gains and taxes, continued 12 Because the sale price is less than the original cost, all of the gain is taxed as ordinary income (depreciation recapture)

Suppose you sell an asset for $22,000 that has a book value of $5,760. And suppose you paid $20,000 for this asset three years ago. If the tax rate on ordinary income is 25% and the tax on capital gains is 20%, what is the tax on this sale? Capital gains and taxes 13

Sale price$22,000 Recapture of depreciation Capital gain Book value5,760 Gain$16,240=$14,240+$2,000 Tax rate25%20% Tax$3,960=$3,560+$400 Capital gains and taxes, continued 14 Because the sale price is greater than the original cost, some of the gain is taxed as ordinary income (depreciation recapture) and some is taxed as capital gain.

The tax rate system in the United States is progressive, with increasing amounts of income taxed at higher rates. Consider the tax rate schedule: Tax Rates 15 Taxable income overbut not overTax rate $ 0$ 50,00015% 50,000 75,00025% 75, ,00034% 100, ,00039% 335,00010,000,00034% 10,000,00015,000,00035% 15,000,00018,333,33338% 18,333,33335%

Tax Rates 16 Income layerRate on layer Tax First $50,00015%$ 7,500 Next $25,00025% 6,250 Next $25,00034% 8,500 Next $235,00039% 91,650 Next $9,665,00034% 3,286,100 Next $1,000,00035% 350,000 $3,750,000 Marginal tax rate = 35% Average tax rate = $3,750,000 ÷ $11,000,000 = 34.09%

 Financial statements are prepared in accordance with a given set of guidelines or principles, which allow comparability across time for a given company and across companies.  Accounting principles allow some flexibility, which is important in having a uniform set of principles applied to companies in different industries and of different sizes.  However, this flexibility puts a burden on those analyzing the financial statements to appreciate the degree of flexibility and the possible effect on the reported financial statements. Summary 17

 The financial statements for a company are constructed based on entries throughout the period.  Because statements are a result of transactions that involve debits and credits, there are linkages among these statements that include the following:  The balance sheet provides the carrying value of assets, liabilities, and equity at a point in time, whereas the income statement is a summary of the revenues and expenses over the period.  The statement of cash flows provides cash flows in terms of the three primary sources/uses: operations, investment, and financing. Summary 18

 For financial reporting purposes, the management of the company may select among several different methods, including declining balance, sum-of-years’-digits, and straight-line.  For tax purposes, companies in the United States must use the MACRS system.  Income for accounting purposes is not likely to be equal to taxable income because of differences in accounting for revenues and expenses.  These differences may give rise to deferred assets (tax benefits to be received in the future) or deferred taxes (tax obligations to be paid in the future). Summary 19