1. 2 2 Chapter Review of Accounting, Financial Statements, and Income Taxes Slides Developed by: Terry Fegarty Seneca College

2. © 2006 by Nelson, a division of Thomson Canada Limited 2 Chapter 2 – Outline (1) Accounting Systems and Financial Statements  The Nature of Financial Statements  Accounting Periods The Income Statement The Balance Sheet  The Balance Sheet—Assets  Tax Amortization and Tax Books  The Balance Sheet—Liabilities  The Balance Sheet—Equity The Statement of Cash Flows  Constructing the Statement of Cash Flows  Free Cash Flows

3. © 2006 by Nelson, a division of Thomson Canada Limited 3 Chapter 2 – Outline (2) Income Taxes  Income Tax Authorities and Tax Bases  Income Tax Formulas  Income Tax Calculations  Progressive Tax System, Marginal and Average Rates  Personal Tax on Investment Income  Tax Rates and Investment Decisions  Capital Gains and Losses  Tax on Dividends

4. © 2006 by Nelson, a division of Thomson Canada Limited 4 Chapter 2 – Outline (3)  Corporate Taxes  How Much Tax Will a Corporation Pay?  Corporate Tax Rates  Effect of Corporate Taxes  Corporate Taxes and Financing

5. © 2006 by Nelson, a division of Thomson Canada Limited 5 The Nature of Financial Statements Financial statements are numerical representations of a firm’s activities for an accounting period  Provide picture of what’s happening within firm and between firm and rest of the world

6. © 2006 by Nelson, a division of Thomson Canada Limited 6 The Nature of Financial Statements The Three Financial Statements  Income statement  Balance sheet  Statement of cash flows Financial statements are associated with particular accounting periods  usually months, quarters, and years—during which accounting system accumulates transactions

7. © 2006 by Nelson, a division of Thomson Canada Limited 7 Financial Statements and Accounting Periods The income statement  reports revenue earned and costs and expenses incurred over accounting period. The difference is profit The balance sheet  reports that, at end of accounting period, company owns certain assets and owes certain liabilities, Difference is owners’ equity The statement of cash flows  reports cash receipts and cash disbursements over accounting period. Difference is net cash flow

8. © 2006 by Nelson, a division of Thomson Canada Limited 8 Table 2.1 : The Income Statement

9. © 2006 by Nelson, a division of Thomson Canada Limited 9 The Income Statement (1) Sales (AKA: revenue)  Total receipts from selling goods from normal business operations If firm receives money from activities outside normal business operations, it will be recorded as other income Cost of Goods Sold  Represents money spent on items related to production or purchase of product being sold For instance, in retail business, represents wholesale cost of product

10. © 2006 by Nelson, a division of Thomson Canada Limited 10 The Income Statement (2) Gross Margin  Represents Sales revenue less Cost of goods sold Fundamental measure of profitability Expenses  Represent spending on items that are not closely related to production, such as marketing or accounting Both Expenses and Cost of goods sold may include amortization

11. © 2006 by Nelson, a division of Thomson Canada Limited 11 The Income Statement (3) Earnings Before Interest and Taxes (EBIT )  Business’s profit before financing charges AKA: Operating profit Helps judge strength of business operations without considering interest expense on debt Interest Expense  Price firm pays for borrowing money Earnings Before Tax (EBT)  Represent Gross margin less all expenses except taxes

12. © 2006 by Nelson, a division of Thomson Canada Limited 12 The Income Statement (4) Tax  refers to income taxes on EBT Doesn’t necessarily mean tax actually due Net Income  Represents “bottom line”—calculated by subtracting tax from EBT AKA: Earnings after Tax (EAT)  Belongs to company’s owners and can be paid out as dividends or retained by company

13. © 2006 by Nelson, a division of Thomson Canada Limited 13 Table 2.2 : The Balance Sheet

14. © 2006 by Nelson, a division of Thomson Canada Limited 14 The Balance Sheet Shows where business’s money has come from and what it’s been used for  All sources of money and all uses must balance Money sources include creditors and owners  Borrowing money from creditor creates liability Has two sides  Assets (=) liabilities + equity

15. © 2006 by Nelson, a division of Thomson Canada Limited 15 The Balance Sheet Liquidity—ease with which an asset becomes cash  Assets and liabilities are arranged in order of decreasing liquidity For instance, current assets are listed first, with cash being first current asset listed

16. © 2006 by Nelson, a division of Thomson Canada Limited 16 The Balance Sheet—Assets (1) Current Assets  Assets that can be expected to become cash within one year  Include Cash, Accounts receivable and Inventory  All money received from normal business operations flows through current accounts

17. © 2006 by Nelson, a division of Thomson Canada Limited 17 The Balance Sheet—Assets (2) Cash  Money in chequing accounts plus currency on hand  Marketable securities or cash equivalents—liquid investments held instead of cash Short-term, modest return, low risk Used by larger companies

18. © 2006 by Nelson, a division of Thomson Canada Limited 18 The Balance Sheet—Assets (3) Accounts Receivable  Represent credit sales that have not yet been paid Allowance for doubtful accounts: provision for credit sales that will never be paid Writing off a receivable: when receivable is known to be uncollectible, accounts receivable reduced by that amount

19. © 2006 by Nelson, a division of Thomson Canada Limited 19 The Balance Sheet—Assets (4) Inventory  Product held for sale in normal course of business Manufacturing firms will have raw materials, work-in-process and finished goods The inventory allowance: inventory balances are usually reported net of an allowance for unusable inventory Writing off bad inventory: when inventory is identified as missing, damaged, or obsolete, balance sheet inventory account reduced to reflect the loss

20. © 2006 by Nelson, a division of Thomson Canada Limited 20 The Balance Sheet—Assets (5) Overstatements  Overstatement of accounts receivable and inventory can be significant problem to users of financial statements  If these accounts are overstated, firm’s value and net income are less than what are being reported  Can also mean firm is not managed efficiently

21. © 2006 by Nelson, a division of Thomson Canada Limited 21 The Balance Sheet—Assets (6) Capital Assets  Predominant item includes property, plant and equipment (PPE)  ‘Capital’ implies long-lived—useful life of at least one year

22. © 2006 by Nelson, a division of Thomson Canada Limited 22 The Balance Sheet—Assets (7) Capital Assets—Amortization  Accounting procedure that spreads cost of capital asset over its estimated useful life  Asset remaining in use beyond its amortized life is said to be fully amortized  Sometimes amortization can be front-loaded using an accelerated amortization method  Balance Sheet Presentation Capital assets presented net of accumulated amortization

23. © 2006 by Nelson, a division of Thomson Canada Limited 23 Table 2.3: Capital Asset Amortization

24. © 2006 by Nelson, a division of Thomson Canada Limited 24 Tax Amortization and Tax Books Government allows businesses to use two sets of books  Tax books—generated according to the tax rules (usually result in lower taxable income and lower taxes)  Financial books—used for financial reporting purposes Usually report higher profits due to differing amortization method  Difference in taxes is placed in deferred tax account on financial books

25. © 2006 by Nelson, a division of Thomson Canada Limited 25 The Balance Sheet—Liabilities (1) Represent what company owes to creditors Current Liabilities  Items requiring payment within one year, such as Accounts payable, Accruals, Notes payable, etc. Working Capital  Total current assets—known as gross working capital  Net working capital = Current assets – Current liabilities

26. © 2006 by Nelson, a division of Thomson Canada Limited 26 The Balance Sheet—Liabilities (2) Accounts payable  What firm owes when it buys from vendors on credit (called trade credit) Usually arises with purchase of inventory  Terms of Sale Length of time allowed until payment is due on credit sale May include discount for early payment 2/10, n/30, for instance  Delaying payment—known as stretching payables or leaning on the trade Abuse of vendor’s terms may result in cancellation of credit privileges

27. © 2006 by Nelson, a division of Thomson Canada Limited 27 The Balance Sheet—Liabilities (3) Accruals  Expenses and liabilities for incomplete transactions at end of accounting period  Common examples—unpaid wages, interest, taxes

28. © 2006 by Nelson, a division of Thomson Canada Limited 28 The Balance Sheet—Liabilities (4) Long-term Debt  Usually consists of bonds and long-term loans  Leverage Use of debt as a source of funds If things are going well, leverage can improve return on owner’s investment  Fixed Financial Charges Interest charges on debt are fixed If business performs well or poorly, owes same amount of interest Many businesses have gone bankrupt due to inability to pay fixed financial obligations

29. © 2006 by Nelson, a division of Thomson Canada Limited 29 The Balance Sheet—Equity (1) Funds supplied to business corporations by their shareholders either through  Direct investment or  Retained earnings Direct Investment by Shareholders  Total amount of money paid for an issue of shares Common shares Common shareholders own the corporation Preferred shares A cross between debt and common shares

30. © 2006 by Nelson, a division of Thomson Canada Limited 30 The Balance Sheet—Equity (2) Retained Earnings  Company’s profits can be paid to its shareholders (generally through dividends) or retained in the business Money retained for reinvestment still belongs to owners  Does not represent a cash balance  Shows all the earnings ever retained by the firm

31. © 2006 by Nelson, a division of Thomson Canada Limited 31 The Balance Sheet—Equity (3) The Relationship Between Net Income and Equity  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 + new shares issued = ending equity

32. © 2006 by Nelson, a division of Thomson Canada Limited 32 The Statement of Cash Flows Income does not represent cash in firm’s bank account The Statement of Cash Flows provides info on movement of cash in and out of company Constructed from Balance Sheet and Income Statement

33. © 2006 by Nelson, a division of Thomson Canada Limited 33 The Statement of Cash Flows Cash Flow Rules  To construct a statement of cash flows Cash income  cash inflow Cash loss  cash outflow Asset increase  cash outflow Asset decrease  cash inflow Liability increase  cash inflow Liability decrease  cash outflow Equity increase  cash inflow Equity decrease  cash outflow

34. © 2006 by Nelson, a division of Thomson Canada Limited 34 The Statement of Cash Flows Statement of Cash Flows is organized to show  Operating activities Running business on day-to-day basis  Investing activities When firm buys or sells things to do business Includes purchases and sales of long-term financial assets  Financing activities When firm borrows money, pays off loans, sells shares or pays dividends

35. © 2006 by Nelson, a division of Thomson Canada Limited 35 Constructing the Statement of Cash Flows—Example Example Also assume firm paid a $500 dividend and sold shares for $800 during the year.

36. © 2006 by Nelson, a division of Thomson Canada Limited 36 Constructing the Statement of Cash Flows Operating activities  Involve Income Statement and Balance Sheet current accounts  Involves activities firm does on day-to-day basis such as Buying inventory Producing and selling product Paying expenses and taxes Collecting credit sales Focus of activities is generating net income—the beginning of a cash flow statement.

37. © 2006 by Nelson, a division of Thomson Canada Limited 37 Constructing the Statement of Cash Flows—Example For Belfry, cash from operating activities is: Net Income$1,000 + Amortization$500 = Operating income$1,500 + increase in receivables$100 - increase in inventory($1,200) + increase in payables$600 - decrease in accruals($100) Cash from operating activities $900 Example

38. © 2006 by Nelson, a division of Thomson Canada Limited 38 Constructing the Statement of Cash Flows Investing activities  Typically include purchasing Capital assets  Examine the change in Gross Capital assets, not Net Because the net value includes adjustment for amortization Amortization has already been included under Operating activities  For Belfry, cash from investing activities is Purchase of capital assets ($2,000) Example

39. © 2006 by Nelson, a division of Thomson Canada Limited 39 Constructing the Statement of Cash Flows Financing activities  Deal with long-term debt and equity  For Belfry, cash from financing activities is: Increase in long-term debt Sale of shares $1,200 800 Dividend paid 2,000 (500) Cash from financing activities$1,500 Example

40. © 2006 by Nelson, a division of Thomson Canada Limited 40 Constructing the Statement of Cash Flows The Equity Accounts  Changes in equity are already shown elsewhere Net Income is included in Cash flows from operating activities Sale of shares and dividends are considered under Cash flows from financing activities

41. © 2006 by Nelson, a division of Thomson Canada Limited 41 Constructing the Statement of Cash Flows The Cash Account  Sum of cash flows from operating activities, financing activities and investing activities must equal the change in cash  For Belfry, change in cash balance is: Beginning cash balance$1,000 Net cash flow400 Ending cash balance$1,400 Example

42. © 2006 by Nelson, a division of Thomson Canada Limited 42 Constructing the Statement of Cash Flows—Example While the firm was profitable it still had to borrow money and sell shares to finance the increase in capital assets. Example

43. © 2006 by Nelson, a division of Thomson Canada Limited 43 Free Cash Flows Cash flows from operating activities  Some may be used to maintain long-run competitive position Replace worn-out capital assets Pay dividends Free cash flow (FCF) refers to cash generated beyond these needs  Free cash flow = Cash flow from operating activities Minus:Capital expenditures Minus:Dividends

44. © 2006 by Nelson, a division of Thomson Canada Limited 44 Income Taxes Authorities and Tax Bases  In Canada income tax is levied on both individuals and corporations  There are two taxing levels  Federal  Provincial

45. © 2006 by Nelson, a division of Thomson Canada Limited 45 Income Tax Formulas (1) Total income – Tax deductions = Taxable income (2) Taxable income × Tax rates = Total tax (3) Total tax – Tax credits = Net tax payable

46. © 2006 by Nelson, a division of Thomson Canada Limited 46 Income Tax Calculations Income taxes are calculated on taxable income Income subject to tax less certain deductions Tax rates—combined rates levied by the federal and provincial governments on taxable income to determine tax payable Rate schedules for corporations and people are very different as are rules for calculating taxable income Tax credits may be available to reduce tax otherwise payable

47. © 2006 by Nelson, a division of Thomson Canada Limited 47 Progressive Tax System, Marginal and Average Rates Income tax system for individuals is progressive  Progressive tax system: higher tax rates on higher income  Tax bracket: range of income in which tax rate is constant  Marginal tax rate: rate that will be paid on next dollar of income  Average tax rate: total taxes paid as a percentage of total income

48. © 2006 by Nelson, a division of Thomson Canada Limited 48 Table 2.4: Combined Personal Tax Brackets and Tax Rates, 2003

49. © 2006 by Nelson, a division of Thomson Canada Limited 49 Personal Taxes on Investment Income Governments levy tax on various types of personal income, including investment income  interest from bonds  dividends on shares  capital gains from the sale of securities. Each type of investment income is taxed differently.  Interest income is taxed at person’s marginal rate  Tax on dividends is reduced by dividend tax credits  Only 50% of capital gains to subject to tax

50. © 2006 by Nelson, a division of Thomson Canada Limited 50 Capital Gains and Losses Capital gain (loss) arises when long-term asset that’s held for investment is sold for more (less) than was paid for it Capital gains receive more favourable tax treatment than ordinary income in order to encourage investment  Currently, only 50% of a capital gain is subject to tax  Capital losses can be used to offset capital gains

51. © 2006 by Nelson, a division of Thomson Canada Limited 51 Capital Gains and Losses Taxable capital gain:  Proceeds on sale of the asset$  Less the cost of the asset$  Less the expenses to sell the asset$  Equals the capital gain$  Less the exempt portion – 50%$  Equals the taxable capital gain$

52. © 2006 by Nelson, a division of Thomson Canada Limited 52 Tax on Capital Gains—Example Q. During the last tax year, Helen Zhou sold an investment property for $80,000 that she had purchased three years earlier for $53,000. She also sold some Nortel shares for $4,000 for which she had paid $12,000 two years before. What is her taxable capital gain? A. Gain on investment property $27,000 Loss on shares (8,000) Net capital gain $19,000 Taxable capital gain (50%) $9,500 Example

53. © 2006 by Nelson, a division of Thomson Canada Limited 53 Tax on Dividends Dividends received from Canadian corporations also receive beneficial tax treatment Individual investors who receive such dividends are entitled to dividend tax credits, which reduce their effective tax rates on dividend income

54. © 2006 by Nelson, a division of Thomson Canada Limited 54 Table 2.5 : Taxes on Interest, Dividend, and Capital Gains Income, 2003

55. © 2006 by Nelson, a division of Thomson Canada Limited 55 Tax Rates and Investment Decisions Investors need to consider the different tax treatments in making investment decisions.  It is after-tax, not before-tax, income that counts.  Corporations allow for these different tax treatments when considering financing methods and distributions to their investors

56. © 2006 by Nelson, a division of Thomson Canada Limited 56 Corporate Taxes A corporation is liable for Canadian corporation taxes if it  was incorporated in Canada  is managed from Canada  or operates in Canada. A corporation must file both federal and provincial tax returns Income taxes on corporate profits can significantly reduce a corporation’s earnings and cash flow.

57. © 2006 by Nelson, a division of Thomson Canada Limited 57 How Much Tax Will A Corporation Pay? Total income is business’s revenue Deductions are Cost of goods sold and expenses required to run the company A company’s Earnings before tax (EBT) represent corporation’s taxable income

58. © 2006 by Nelson, a division of Thomson Canada Limited 58 How Much Tax Will A Corporation Pay? Adjustments to Corporate Income  Dividends Paid to Corporations Dividends received from another corporation are deductible by the receiving corporation  Tax Loss Carry Back and Carry Forward Business losses can be carried backward or forward in time to offset taxes

59. © 2006 by Nelson, a division of Thomson Canada Limited 59 How Much Tax Will A Corporation Pay? Corporate tax rates do not rise consistently as taxable income rises  Corporations generating high incomes pay a constant rate on all their income  Rate reductions for small private corporations and manufacturing businesses Some corporate tax credits allowed

60. © 2006 by Nelson, a division of Thomson Canada Limited 60 Table 2.6 : Combined Corporate Tax Rates on Private Corporations with Active Business Income

61. © 2006 by Nelson, a division of Thomson Canada Limited 61 Corporate Taxes—Example Q:Using the corporate tax rates in Table 2.6, calculate the tax liability for a private corporation (CCPC) making EBT of $330,000. A:Applying the corporate tax table results in the following tax liability: Example 70,100 Total 4,100$10,000 x 0.41 6,000$20,000 x 0.30 17,250$75,000 x 0.23 42,750$225,000 x 0.19

62. © 2006 by Nelson, a division of Thomson Canada Limited 62 Table 2.7: Combined Corporate Tax Rates on Business Income (Corporations Other Than CCPCs), 2003

63. © 2006 by Nelson, a division of Thomson Canada Limited 63 Effect of Corporate Taxes Taxes affect most financial transactions:  Dividend policy: capital gains versus dividend policy  Capital budgeting: return on investment  Leasing: motivated by tax effects  Capital structure policy: tax advantage of debt financing

64. © 2006 by Nelson, a division of Thomson Canada Limited 64 Corporate Taxes and Financing Taxes and Financing  The corporate tax system favors debt financing over share financing  Interest payments made to debt investors are tax deductible Dividend payments to equity investors are not tax deductible  If two companies generated the same EBT, but one firm was financed entirely with debt, firm with debt financing would have lower tax liability