1. Financial Statements, Taxes and Cash Flow Prepared by Anne Inglis2
Financial Statements, Taxes and Cash Flow Prepared by Anne Inglis

2. Key Concepts and Skills
Understand the difference between accounting value (or “book value) and market value.
Know the difference between accounting income and cash flow.
Know how to determine a firm’s cash flow from its financial statements.
Understand the difference between average and marginal tax rates.
Understand the basics of Capital Cost Allowance (CCA) and Undepreciated Capital Cost (UCC).
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Chapter Outline
Statement of Financial Position
Statement of Comprehensive Income
Statement of Cash Flows
Taxes
Capital Cost Allowance
Summary and Conclusions
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4. Statement of Financial Position - 2.1
LO1
The statement of financial position is a snapshot of the firm’s assets and liabilities at a given point in time
Assets are listed in order of liquidity
Ease of conversion to cash
Without significant loss of value
Statement of Financial Position Identity
Assets = Liabilities + Stockholders’ Equity
Liquidity is a very important concept. Students tend to remember the “convert to cash quickly” component of liquidity, but often forget the part about “without loss of value.” Remind them that we can convert anything to cash quickly if we are willing to lower the price enough, but that doesn’t mean it is liquid.
Also, point out that a firm can be TOO liquid. Excess cash holdings lead to overall lower returns.
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5. Statement of Financial Position - Figure 2.1
LO1
The left-hand side lists the assets of the firm. Current assets are listed first because they are the most liquid. Fixed assets can include both tangible and intangible assets, and they are listed at the bottom because they generally are not very liquid. These are direct result of management’s investment decisions. (Please emphasize that “investment decisions” are not limited to investments in financial assets.)
Note that the statement of financial position does not list some very valuable assets, such as the people who work for the firm. The liabilities and equity (or ownership) components of the firm are listed on the right-hand side. This indicates how the assets are paid for. Since the statement of financial position has to balance, total equity = total assets – total liabilities. The portion of equity that can most easily fluctuate to create this balance is retained earnings. The right-hand side of the statement of financial position is a direct result of management’s financing decisions.
Remember that shareholders’ equity consists of several components and that total equity includes all of these components not just the “common stock” item. In particular, remind students that retained earnings belong to the shareholders.
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Net Working Capital
LO1
Net Working Capital
Current Assets – Current Liabilities
Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out
Usually positive in a healthy firm
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Liquidity
LO1
Liquidity
Ability to convert to cash quickly without a significant loss in value
Liquid firms are less likely to experience financial distress
However, liquid assets earn a lower return
Tradeoff between liquid and illiquid assets
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8. Canadian Enterprises Statement of Financial Position – Table 2.1
LO1
Here is an example of a simplified statement of financial position. Many students make it through business school without ever seeing an actual statement of financial position, particularly those who are not majoring in finance or accounting. This is a good place to talk about some of the specific types of items that show up on a statement of financial position and remind the students what accounts receivable, accounts payable, notes payable, etc. are.
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Value versus Cost
LO1
The statement of financial position provides the book value of the assets, liabilities and equity.
Market value is the price at which the assets, liabilities or equity can actually be bought or sold.
Market value and book value are often very different. Why?
Which is more important to the decision-making process?
Current assets and liabilities generally have book values and market values that are very close. This is not necessarily the case with the other assets, liabilities and equity of the firm. In 2011, International Financial Reporting Standards (IRFS) were introduced that allow a company to revaluate the firm’s assets to reflect fair market value. The statement of financial position does not include the value of many important assets, such as human capital. Consequently, the “Total Assets” line on the statement of financial position is generally not a very good estimate of what the assets of the firm are actually worth.
Liabilities are listed at face value. When interest rates change or the risk of the firm changes, the value of those liabilities change in the market. This is especially true for longer-term liabilities.
Equity is the ownership interest in the firm. The market value of equity (stock price times number of shares) depends on the future growth prospects of the firm and on the market’s estimation of the current value of ALL of the assets of the firm.
The best estimate of the market value of the firm’s assets is market value of liabilities + market value of equity.
Market values are generally more important for the decision making process because they are more reflective of the cash flows that would occur today.
It is difficult to compare financial statements from different countries, since every country’s accounting conventions are different. To help international investors, many countries are moving toward adopting International Financial Reporting Standards (IFRS), which seeks to simplify comparisons of financial statements prepared in different countries. IFRS is already in place in the EU, Australia and South Africa, but notably not in the US – this complicates interpretation of and comparisons between financial statements for companies that operate in both the US and Canada.
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10. International Financial Reporting Standards (IFRS)
LO1
IFRS allows companies to use the historical cost method
Also allows use of the revaluation (fair value) method
All items in an asset class should be revalued simultaneously
Revaluation should be performed with enough regularity to ensure that the carrying amount is not materially different from the fair value
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11. Example 2.2 - Quebec Corporation
LO1
QUEBEC CORPORATION
Statement of Financial Position
Market Value versus Book Value
Book
Market
Assets
Liabilities and Shareholders’ Equity
NWC
$ 400
$ 600
LTD
$ 500
NFA
700
1,000 SE
600
1,100
1,600
Shareholders are the ones that benefit from increases in the market value of a firm’s assets. They are also the ones that bear the losses of a decrease in market value. Consequently, managers need to consider the impact of their decisions on the market value of assets, not on their book value. Here is a good illustration:
Suppose that the MV of assets declined to $700 and the market value of long-term debt remained unchanged. What would happen to the market value of equity? It would decrease to 700 – 500 = 200.
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12. Statement of Comprehensive Income - 2.2
LO1
The statement of comprehensive income is more like a video of the firm’s operations for a specified period of time.
You generally report revenues first and then deduct any expenses for the period
Matching principle – IFRS say to show revenue when it accrues and match the expenses required to generate the revenue
Matching principle – this principle leads to non-cash deductions like depreciation. This is why net income is NOT a measure of the cash flow during the period.
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13. Canadian Enterprises Statement of Comprehensive Income – Table 2.2
LO1
Remember that this is a simplified statement of comprehensive income for illustrative purposes.
Earnings before interest and taxes is often called operating income.
COGS would include both the fixed costs and the variable costs needed to generate the revenues.
Analysts often look at EBITDA (earnings before interest, taxes, depreciation and amortization) as a measure of the operating cash flow of the firm. It is not true in the strictest sense because taxes are an operating cash flow as well, but it does provide a reasonable estimate for analysis purposes.
It is important to point out that depreciation expense is often figured two different ways, depending on the purpose of the financial statement. If we are computing the taxes that we will owe, we use the depreciation schedule provided by the Customs and Revenue Agency (CRA). In this instance, the “life” of the asset for depreciation purposes may be very different from the useful life of the asset.
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Work the Web Example
LO1
Publicly traded companies must file regular reports with the Ontario Securities Commission
These reports are usually filed electronically and can be searched at the SEDAR site
Click on the web surfer, pick a company and see what you can find!
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15. Statement of Cash Flows - 2.3
Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements
We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets
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Cash Flow From Assets
LO3
Cash Flow From Assets (CFFA) = Cash Flow to Bondholders + Cash Flow to Shareholders
Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC
The first equation is how the cash flow from the firm is divided among the investors that financed the assets.
The second equation is the cash flow that the firm receives from its assets. This is an important equation to remember. We will come back to it and use it again when we do our capital budgeting analysis. We want to base our decisions on the timing and risk of the cash flows we expect to receive from a project.
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17. Example: Canadian Enterprises
LO3
Operating Cash Flow (I/S) = EBIT + depreciation – taxes = $509
Net Capital Spending (B/S and I/S) = ending net fixed assets – beginning net fixed assets + depreciation = $130
Changes in NWC (B/S) = ending NWC – beginning NWC = $330
Use the information from the statement of financial position and statement of comprehensive income presented previously to work through this example.
OCF = – 250 = 509
NCS = 1709 – = 130
Students often have a difficult time understanding why a cash outflow has a positive sign and a cash inflow has a negative sign. Emphasize that we are talking about SPENDING in the net capital spending formula and Investment in NWC. The formula for CFFA takes care of reducing cash flow when NCS is positive and increasing CF when it is negative.
Ending NWC = 1403 – 389 = 1014
Beginning NWC = 1112 – 428 = 684
Changes in NWC = 1014 – 684 = 330
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Example continued
Cash Flow From Assets (CFFA) = – 130 – 330 = $49
CF to Creditors (B/S and I/S) = interest paid – net new borrowing = $24
CF to Stockholders (B/S and I/S) = dividends paid – net new equity raised = $25
CFFA = = $49
Net New Borrowing = ending LT debt – beginning LT debt = 454 – 408 = 46
CF to creditors = 70 – 46 = 24
Net New Equity = 640 – 600 = 40 (Be sure to point out that we want equity raised in the capital markets, not retained earnings.
CF to Stockholders = 65 – 40 = 25
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19. Cash Flow Summary Table 2.4
This provides a summary for the various cash flow calculations. It is a good place to refer back when working on cash flows in the capital budgeting section.
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Example: Statement of Financial Position and Income Statement Information
LO3
Current Accounts
2011: CA = 1500; CL = 1300
2012: CA = 2000; CL = 1700
Fixed Assets and Depreciation
2011: NFA = 3000; 2009: NFA = 4000
Depreciation expense = 300
LT Liabilities and Equity
2011: LTD = 2200; Common Equity = 500; RE = 500
2012: LTD = 2800; Common Equity = 750; RE = 750
Statement of Comprehensive Income Information
EBIT = 2700; Interest Expense = 200; Taxes = 1000; Dividends = 1250
Here is the additional information required to complete the statement of comprehensive income. You may want to give them this information and have them practice putting together a statement of financial position and statement of comprehensive income.
Sales = 5000; Costs = 2000
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Example: Cash Flows
LO3
OCF = – 1000 = 2000
NCS = 4000 – = 1300
Changes in NWC = (2000 – 1700) – (1500 – 1300) = 100
CF From Assets = 2000 – 1300 – 100 = 600
CF to Bondholders = 200 – (2800 – 2200) = -400
CF to Shareholders = 1250 – (750 – 500) = 1000
CF From Assets = = 600
The CF identity holds.
Remind the students that changes in Retained Earnings are not included because there is no cash flow associated with them. Net new equity consists of the purchase and sale of stock in the market. If the company had purchased back stock during the year, you would need to include the change in the Treasury stock account. An increase in Treasury Stock is a decrease in net new equity since it is a cash outflow from the firm to stockholders.
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Taxes - 2.4
LO4
Individual vs. corporate taxes
Marginal vs. average tax rates
Marginal – the percentage paid on the next dollar earned
Average – the percentage of your income that goes to pay taxes (tax bill / taxable income)
Ask the class how many of them fill out their own tax returns every year, as opposed to paying someone else (i.e. an accountant, an online service, etc.) to do it for them. People are often intimidated to do their own taxes and admittedly it is a bit confusing the first year, but they can gain a much deeper understanding of the tax system by doing it for a few years. The tax department (Canada Customs and Revenue Agency) is very helpful with questions and easy to get in touch with by phone. There are also often tax seminars held in the community around tax time.
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Taxes on Investments
LO4
When an investor holds stocks, they are subject to two types of taxes:
Dividend tax credit – A tax formula that reduces the effective tax rate on dividends
Capital gains tax – Tax is paid on the investment’s increase in value over its purchase price
The dividend tax credit was designed to compensate for the double taxation faced by taxing first at the corporate level and then again at the individual level. This tax credit applies to dividends paid by corporations resident in Canada only. It involves grossing up the actual dividend paid by the corporation by 45%. Federal tax is then calculated on the grossed up number. Then a tax credit of 19% is subtracted from the federal tax to get the actual tax payable.
Despite the complicated formula for the dividend tax credit (which is provided in a little more detail in the text), you can help make it more intuitive for your students by explaining that corporate taxes are effectively a withholding tax on earnings. Earnings are first taxed at the corporate level. Then, for domestic investors, the tax owing on dividends is reduced on their individual tax returns, the amount of which depends on their individual tax bracket.
Individuals in Canada have an incentive to hold dividend paying stocks as dividends are taxed marginally less than capital gains.
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24. Capital Cost Allowance (CCA) - 2.5
CCA is depreciation for tax purposes
CCA is deducted before taxes and acts as a tax shield
Every capital asset is assigned to a specific asset class by the government
Every asset class is given a depreciation method and rate
Half-year Rule – In the first year, only half of the asset’s cost can be used for CCA purposes
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25. Some CCA Classes – Table 2.9
LO5
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26. Example: CCA Calculation
LO5
ABC Corporation purchased $100,000 worth of photocopiers in Photocopiers fall under asset class 8 with a CCA rate of 20%. How much CCA will be claimed in 2011 and 2012?
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27. Beginning Fixed Assets
CCA Example – Solution
LO5
Year
Beginning Fixed Assets
CCA
Ending Fixed Assets
2011
50000 (100,000 x 50%)
10,000 (50,000 x 20%)
40000 (50, ,000)
2012
90,000 (40, ,000)
18,000 (90,000 x 20%)
72,000 (90, ,000)
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28. CCA – Additional Concepts
LO5
Usually firms have multiple machines (i.e. more than one photocopier) in an asset class.
When an asset is sold, the asset class is reduced by the realized value of the asset, or by its original cost, whichever is less.
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Closing an Asset Class
LO5
When the last asset in an asset class is sold, the asset class is terminated. This can result in a terminal loss or recaptured CCA.
Terminal Loss – The difference between the UCC and the adjusted cost when the UCC is greater.
Recaptured CCA – The taxable difference between the adjusted cost and the UCC when the UCC is smaller.
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Another CCA Example
LO5
Kool Drinks Corporation purchased $300,000 worth of bottling machinery in Machinery falls under asset class 43 with a CCA rate of 30%. In 2012, Kool Drinks sold their machinery for $150,000 and moved their production to Mexico. Was there a capital gain, a CCA recapture or a terminal loss? What if the machinery was sold for $120,000?
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31. Another CCA Example - Solution
LO5
Year
Beginning
UCC
CCA
Ending
2010
150,000
45,000
105,000
2011
255,000
76,500
178,500
2012
53,550
124,950
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32. Another CCA Example Solution continued
LO5
There is no capital gain because the machinery was sold for less than its original cost of $300,000.
At $150,000, there is a CCA recapture of $25,050
At $120,000 there is a terminal loss of $4,950
CCA Recapture = 150,000 – 124,950 = 25,050
Terminal Loss = 120,000 – 124,950 = (-4,950)
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Quick Quiz
What is the difference between book value and market value? Which should we use for decision making purposes?
What is the difference between accounting income and cash flow? Which do we need to use when making decisions?
What is the difference between average and marginal tax rates? Which should we use when making financial decisions?
How do we determine a firm’s cash flows? What are the equations and where do we find the information?
What is CCA? How is it calculated?
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Summary 2.6
The statement of financial position shows the firm’s accounting value on a particular date.
The statement of comprehensive income summarizes a firm’s performance over a period of time.
Cash flow is the difference between the dollars coming into the firm and the dollars that go out.
Cash flows are measured after-tax.
CCA is depreciation for tax purposes in Canada. Remember the half-year rule.
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