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Chapter Two – Financial Background: A Review of Accounting, Financial Statements and Taxes

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ACCOUNTING SYSTEMS Keep financial records and produce statements FINANCIAL STATEMENTS Income Statement Balance Sheet Statement of Cash Flows Accounting Results Can Be Counterintuitive
Income isn't cash in hand E.g.: Receivables Depreciation TM Slide 1 of 2

3. ACCOUNTING BASICS Two sides to every entry
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ACCOUNTING BASICS
The Double Entry System
Two sides to every entry
Where the money came from and what it's used for
"Balanced Books"
Stocks and Flows
Flows over a period: Income and Cash Statements
Stocks at a point in time: Balance Sheet
Accounting Periods
Accumulate transactions
Closing the books
TM Slide 2 of 2

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INCOME STATEMENT
Sales $1,000 Cost of Goods Sold Gross Margin $400 Expenses Earnings Before Interest & Taxes $170 Interest Expense Earnings Before Tax $150 Tax Net Income $100 Table 2-1 A Conventional Income Statement Format TM 2-2 Slide 1 of 3

5. Sales - Revenue Proceeds from sale of product or service (only)
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Sales - Revenue Proceeds from sale of product or service (only)
COGS Spending on things closely related to production
Material, labor, production overhead Gross Margin Profitability of production operations Often expressed as a percent of sales
Expenses Other spending - Marketing, finance, human resources
TM Slide 2 of 3

6. EBT Earnings before taxes
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EBIT Earnings before interest and taxes The result of physical operations before financing costs INTEREST
On borrowed capital
EBT Earnings before taxes
Tax On EBT Actual tax may be different Tax vs. financial books Net Income The bottom line – dividends not subtracted

7. BALANCE SHEET ASSETS LIABILITIES & EQUITY Cash $1,000 Accounts
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BALANCE SHEET
ASSETS LIABILITIES & EQUITY
Cash $1,000 Accounts
Accounts Payable $1,500
Receivable 3,000 Accruals
Inventory 2,000
CURRENT CURRENT
ASSETS $6, LIABILITIES $2,000
Fixed Assets Long Term Debt $5,000
Gross $4,000 Equity ,000
Accum Depr (1,000)
Net $3,000 TOTAL CAPITAL $7,000
TOTAL LIABILITIES
TOTAL ASSETS $9,000 AND EQUITY $9,000
ASSETS = LIABILITIES + EQUITY
Arrangement in order of decreasing liquidity

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ASSETS Cash Checking accounts + Currency Accounts Receivable Due from sales on credit Offset-Allowance for doubtful accounts(bad debt reserve) Writing off of uncollectibles Overstatement of receivables Inventory Raw Material, WIP, Finished Goods Offset - Inventory reserve Writing off bad inventory Overstatement of inventory

9. Become cash within a year Generally Cash, A/R and Inventory
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Current Assets
Become cash within a year
Generally Cash, A/R and Inventory
Fixed Assets
Long lived - depreciated
Stated Net of Accumulated Depreciation
If sold - cost is NBV
TM Slide 3 of 4

10. Year Income Statement Balance Sheet
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Year Income Statement Balance Sheet
1 Deprec Exp $2, Gross $10,000
Accum Depr (2,500)
Net $7,500
2 Deprec Exp $2, Gross $10,000
Accum Depr (5,000)
Net $5,000
3 Deprec Exp $2, Gross $10,000
Accum Depr (7,500)
Net $2,500
4 Deprec Exp $2, Gross $10,000
Accum Depr (10,000)
Net
Table Fixed Asset Depreciation
TM 2-4 Slide 4 of 4

11. LIABILITIES Terms of sale Stretching payables Understatements
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LIABILITIES
Accounts Payable
Due from purchases on credit
Terms of sale
Stretching payables
Understatements
TM 2-5 Slide 1 of 3

12. Figure 2-1 A Payroll Accrual
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Accruals
Recognizes incomplete transactions
An example:
Thurs Fri Sat Sun Mon Tues Wed Thurs Fri Sat
Payday Payday
End of Month
Close
First Month Second Month
Figure 2-1 A Payroll Accrual

13. Current Assets - Current Liabilities Supports routine operations
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Current Liabilities
Due within a year
Working Capital
Current Assets - Current Liabilities
Supports routine operations
TM 2-5 Slide 3 of 3

14. Debt generates interest expense - Increases
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CAPITAL
LONG TERM DEBT
Bonds and Loans
Debt generates interest expense - Increases
risk of failure
Leverage
Amplifies return on investment - both ways
TM 2-6 Slide 1 of 3

15. LEVERAGE ILLUSTRATION

16. EQUITY par value and paid in excess accounts Retained Earnings
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Direct Investment by owners paying for stock
par value and paid in excess accounts
Retained Earnings
Example: 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) ,000
Retained Earnings ($70,000 - $15,000) ,000
Total Equity $215,000

17. The Relationship Between Net Income and Retained Earnings
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The Relationship Between Net Income and Retained Earnings
Beginning Equity + Net Income - Dividends + Stock = Ending Equity

18. TAXES Tax Bases and Taxing Authorities
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TAXES
Tax Bases and Taxing Authorities
Income - Federal, State, a few cities
Wealth - Real estate taxes - Cities and counties
Consumption - Sales and excise taxes - all

19. The Total Effective Income Tax Rate
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The Total Effective Income Tax Rate
State tax is deductible from federal tax
Taxable Income for State Tax $ 100
State 10%
Taxable Income for Federal Tax $ 90
Federal 30%
Net After Tax $ 63
Total Tax $ 37
In general: TETR = Tf + Ts(1 - Tf)

20. Progressive Tax Systems
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Progressive Tax Systems
The U.S. federal tax system is progressive in that the tax rate increases with income. In a traditional progressive system a high income taxpayer retains the benefit of low rates on early income

21. Tax Schedules (Tables) and Tax Brackets
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Tax Schedules (Tables) and Tax Brackets
Hypothetical Example:
Bracket Tax Rate
0 - $5, %
$5,000 - $15, %
over $15, %
Brackets are ranges of income through which the tax rate is constant.

22. Marginal and Average Tax Rates
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Marginal and Average Tax Rates
Marginal tax rate - the rate paid on the
last/next dollar of income
Average tax rate - the percent of total income paid in taxes
The marginal rate is relevant for investment decisions because investments are generally made after providing for basic needs

23. Tax Calculations: Progressive System
Calculate the tax on an income of $18,000. $5,000 × .10 = $ 500 $10,000 × .15 = $1,500 $3,000 × .25 = $ 750 $2,750 Average Rate = $2,750 / $18,000 = 15.3% Marginal Rate = 25%

24. PERSONAL TAX SCHEDULES (2015)
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PERSONAL TAX SCHEDULES (2015)
Taxpaying unit is a household, usually a family Married Couples Single Individuals Filing Jointly Income Rate Income Rate 0 - $9,225 10% 0 - $18,450 10% $9,225 - $37,450 15% $18,450 - $74,900 15% $37,450 - $90,750 25% $74,900 - $151,200 25% $90,750 - $189,300 28% $151,200 - $230,450 28% $189,300 - $411,500 33% $230,450 - $411,500 33% $411,500 - $413,200 35% $411,500 - $464,850 35% over $413, % Over $464, % Table 2-4 Personal Tax Schedules

25. Calculate tax on income of $85,000. Married filing Jointly
$18, × .10 = $ 1,845
($74,900 - $18,450) × .15 = $ 8,467.50
($56,450)
($85,000-$74,900) × .25 = $ 2,525
($10,100) $12,837.50

26. CAPITAL GAINS ( LOSSES) AND DIVIDENDS
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CAPITAL GAINS ( LOSSES) AND DIVIDENDS
Income is either ordinary or capital gain/(loss) Historically, capital gains taxed at lower rates as an incentive to investment Rate is currently capped according to household income Low 0% Middle 15% High 20% A maximum of $3,000 in capital losses can offset ordinary income in a year. Remainder can be carried forward.

27. Exempt Income Interest on municipal bonds Exclude from calculations
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Exempt Income
Exempt from taxation:
Interest on municipal bonds
Exclude from calculations
Taxable Income
Income excluding exempt less:
Exemption of $4,000 (in 2015) per person
Itemized Deductions of
* mortgage interest on primary home
* local taxes (income and property)
* charitable contributions
* OR a Standard Deduction

28. CALCULATING PERSONAL TAXES
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CALCULATING PERSONAL TAXES
Example 2-4: The Harris family had the following
income in 2015:
Salaries: Joe $75,000
Sue ,000
Interest on savings acct 2,000
Interest on IBM bonds
Interest on Boston Bonds 1,200
Dividends - Gen Motors

29. The Harris Family’s Taxes
uring 2015 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 $2,800 in real estate taxes. State income tax of $6,000 was withheld from their paychecks during the year. They contributed $1,200 to their church. They have two children living at home. The exemption rate is $4,000 per person. What is their taxable income and their tax liability? Further, what are their marginal and average tax rates?

30. The Harris Family’s Taxes
During 2015 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 $2,800 in real estate taxes. State income tax of $6,000 was withheld from their paychecks during the year. They contributed $1,200 to their church. They have two children living at home. The exemption rate is $4,000 per person. What is their taxable income and their tax liability? Further, what are their marginal and average tax rates?

31. Solution: Salaries $152,000 Mortgage interest $12,000
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Solution:
Ordinary income: Deductions:
Salaries $152,000 Mortgage interest $12,000
Interest ,800 Taxes 8,800
$154,800 Charity 1,200
Total deductions $22,000
Net capital gain or loss:
Loss on property ($3,000) Exemptions:
Gain on stock ,000 $4,000 x 4 = $16,000
Net capital loss ($1,000) Taxable Income $115,800 (excl divs) Total Income $153,800
Use the married filing jointly schedule as follows:
10% of the entire first bracket $18,450 x .10 = $1, % of the amount in the second bracket ($74,900 - $18,450) x .15=8,467.50
25% of the amount in the third bracket ($115,800 - $74,900) x .25 = 10,225
Tax Liability $20,537.50
Tax on dividends $600 x .15 =
Total tax liability $20,627.50
Average tax rate: $20,627.50/$116,700 = 17.67%
Marginal tax rate = bracket rate = 25%
(15% if dividends or capital gains)

32. TAX RATES AND INVESTMENT DECISIONS
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TAX RATES AND INVESTMENT DECISIONS
Comparing corporate (interest taxable) and municipal (interest tax exempt) bonds Must state rates on same basis Multiply the corporate rate by one minus the investor's marginal tax rate

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

34. CORPORATE TAXES Deductions are costs and expenses.
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CORPORATE TAXES
Income is the business's revenue.
Deductions are costs and expenses.
Personal exemptions don't exist
Taxable income is Earnings Before Tax (EBT)
Income per financial books vs. tax books
TM 2-12 Slide 1 of 3

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Income Rate
0 - $50, %
$50,000 - $75, %
$75,000 - $100, %
$100,000 - $335, %
$335,000 - $10,000, %
$10,000,000 - $15,000, %
$15,000,000 - $18,333, %
over $18,333, %
Table Corporate Income Tax Schedule
Notice the up and down rates. Is the system progressive?

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Goals of the system:
1. Progressive: income under $10M taxed at 34% income over $10M taxed at 35%. 2. Lower rates on incomes up to $75, Higher income taxpayers pay the targeted rates on their whole incomes. Surtaxes of 5% and 3% take away the benefit of low early rates as income increases

37. Corporate Tax Examples
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Corporate Tax Examples
Example 2-3
Tax for a corporation making EBT of $280,000.
Solution: 50,000 x = $ 7,500
$25,000 x = ,250
$25,000 x = ,500
$180,000 x = ,200
$92,450

38. Corporate Tax Examples
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Corporate Tax Examples
Example 2-4
Tax for a corporation making EBT of $500,000.
Solution: Between $335,000 and
$10 million, the overall tax rate is 34%.
$500,000 x .34 = $170,000
TM Slide 2 of 3

39. Corporate Tax Examples
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Corporate Tax Examples
Example 2-5
Tax for a corporation making EBT of $16 million.
Solution: The system recovers those benefits to an overall 34% rate up to $10 million.
$10,000,000 x = $3,400,000
$5,000,000 x = 1,750,000
$1,000,000 x = ,000
$5,530,000
Over $18,333,333, calculate a flat 35%
TM Slide 3 of 3

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TAXES AND FINANCING
The U.S. tax system favors debt financing because interest is tax deductible and dividends are not. DEBT EQUITY EBIT $120 $120 Interest 20 - EBT $100 $120 30% EAT $ 70 $ 84 Dividends - 20 Net RE add $70 $ 64

41. DIVIDENDS PAID TO CORPORATIONS
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DIVIDENDS PAID TO CORPORATIONS
Tiered ownership can result in multiple taxation
Corporate tax on B
Dividend: B to A
Corporate tax on A
Dividend: A to shareholders
Personal Tax
Avoided by exempting dividends from one corporation to another
Corporation B
Corporation A
Shareholders

42. DIVIDENDS PAID TO CORPORATIONS
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DIVIDENDS PAID TO CORPORATIONS
Ownership Exemption <20% 70% 20% - 80% 80% >80% 100%

43. TAX LOSS CARRY BACK AND CARRY FORWARD
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TAX LOSS CARRY BACK AND CARRY FORWARD
YEAR
Total
EBT $ $100 ($250) $ $50
Tax (30%)
EAT $ $ 70 ($250) $ ($40)
($100) ($100) ($50)
Adjusted
EBT $ $ $ $ $50
Tax
EAT $ $ $ $ $35
Figure Tax Loss Carry Forward and Carry Back
Over the four year period paying $90 tax on earnings of $50 - impossible.
Losses can be carried back two years and carried forward twenty years.