1. Chapter 2 Financial Background: A Review of Accounting, Financial Statements, and Taxes © 2000 South-Western College Publishing

2. 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 2-1 Slide 1 of 2

3. 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 2-1 Slide 2 of 2

4. Sales $1,000 Cost of Goods Sold 600 Gross Margin $400 Expenses 230 Earnings Before Interest & Taxes$170 Interest Expense 20 Earnings Before Tax$150 Tax 50 Net Income$100 Table 2-1 A Conventional Income Statement Format TM 2-2Slide 1 of 3 INCOME STATEMENT

5. 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, personnel TM 2-2 Slide 2 of 3

6. TM 2-2 Slide 3of 3 EBIT Earnings before interest and taxes The result of physical operations before financing costs EBT Earnings before taxes Tax On EBT Actual tax may be different Tax vs. financial books The deferred tax account EAT - PAT - Net Income The bottom line Notice that dividends have not been taken out

7. BALANCE SHEET ASSETSLIABILITIES Cash $1,000Accounts Accounts Payable$1,500 Receivable 3,000Accruals 500 Inventory 2,000CURRENT ASSETS$6,000LIABILITIES $2,000 Fixed AssetsLong Term Debt $5,000 Gross $4,000Equity 2,000 Accum Depr (1,000) Net $3,000TOTAL CAPITAL$7,000 TOTAL LIABILITIES TOTAL ASSETS $9,000 AND EQUITY $9,000 Table 2-2 A Conventional Balance Sheet Format ASSETS = LIABILITIES + EQUITY Arrangement in order of decreasing liquidity TM 2-3Slide 1 of 4

8. 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 TM 2-3 Slide 2 of 4

9. Current Assets Due within a year Fixed Assets Long lived - depreciated Stated Net of Accumulated Depreciation If sold - cost is NBV TM 2-3 Slide 3 of 4

10. Year Income Statement Balance Sheet 1Deprec Exp $2,500 Gross $10,000 Accum Depr (2,500) Net $7,500 2Deprec Exp $2,500 Gross $10,000 Accum Depr (5,000) Net $5,000 3Deprec Exp $2,500 Gross $10,000 Accum Depr (7,500) Net $2,500 4Deprec Exp $2,500 Gross $10,000 Accum Depr (10,000) Net -0- Table 2-3 Fixed Asset Depreciation TM 2-3Slide 4 of 4

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

12. 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 TM 2-5Slide 2 of 3

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

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

15. EQUITY 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) 120,000 Retained Earnings ($70,000 - $15,000) 55,000 Total Equity $215,000 TM 2-6Slide 2 of 3

16. The Relationship Between Net Income and Retained Earnings Beginning Equity + Net Income - Dividends + Stock = Ending Equity TM 2-6Slide 3 of 3

17. 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 TM 2-7Slide 1 of 3

18. The Total Effective Income Tax Rate State tax is deductible from federal tax Taxable Income for State Tax $ 100 State tax @ 10% 10 Taxable Income for Federal Tax $ 90 Federal Tax @ 30% 27 Net After Tax $ 63 Total Tax $ 37 In general: TETR = T f + T s (1 - T f ) TM 2-7Slide 2 of 3

19. 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 TM 2-7Slide 3 of 3

20. Tax Schedules (Tables) and Tax Brackets Hypothetical Example: Bracket Tax Rate 0 - $5,000 10% $5,000 - $15,000 15% over $15,000 25% Brackets are ranges of income through which the tax rate is constant. TM 2-8Slide 1 of 3

21. Marginal and Average Tax Rates Marginal tax rate - the rate paid on the 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 basic needs are provided TM 2-8Slide 2 of 3

22. CAPITAL GAINS(and LOSSES) Income is either ordinary or capital gain/(loss) Historically, capital gains taxed at lower rates as an incentive to investment Rate is currently capped at 28% - Mid-term gains 20% Long-term gains A maximum of $3,000 in capital losses can offset ordinary income in a year. TM 2-8Slide 3 of 3

23. PERSONAL TAX SCHEDULES PERSONAL TAX SCHEDULES (1998) Taxpaying unit is a household, usually a family Married Couples Single Individuals Filing Jointly Income Rate Income Rate 0 - $25,350 15% 0 - $42,350 15% $25,350 - $61,400 28% $42,350 - $102,300 28% $61,400 - $128,100 31% $102,300 - $155,950 31% $128,100 - $278,400 36% $155,950 - $278,450 36% over $278,400 39.6% over $278,450 39.6% Table 2-4 Personal Tax Schedules TM 2-9Slide 1 of 3

24. The Marriage Penalty Single people pay higher rates sooner, but a two income family pays more tax than two single people earning the same total income TM 2-9Slide 2 of 3

25. Exempt Income Exempt Income Exempt from taxation: Interest on municipal bonds Exclude from calculations Taxable Income Gross income less: exemption of $2,700 (in 1998) per person, and deductions of * mortgage interest * local taxes (income and property) * charitable contributions * or a standard deduction TM 2-9Slide 3 of 3

26. CALCULATING PERSONAL TAXES Example 2-1: The Smith family had the following in 1998 : Income:Deductions: Salaries: Joe $45,000 Mortgage Interest$12,000 Sue 42,000 Property Tax 1,800 Interest on savings acct 2,000 State income tax 3,500 Interest on IBM bonds 800 Charitable donations 1,200 Interest on Boston Bonds 1,200 Dividends - Gen Motors 600 Long-term Capital loss on property (3,000)Exemptions: 4 Long-term Capital gain on stock 2,000 Calculate their taxable income and tax liability. What are their marginal and average tax rates? TM 2-10Slide 1 of 2

27. Solution: Ordinary income: Deductions: Salaries $87,000 Mortgage interest $12,000 Interest 2,800Taxes 5,300 Dividends 600Charity 1,200 $90,400 Total deductions $18,500 Net capital gain or loss: Loss on property ($3,000)Exemptions: Gain on stock 2,000$2,700 x 4 = $10,800 Net capital loss ($1,000) Total Income $89,400Taxable Income $60,200 Use the married filing jointly schedule as follows: 15% of the entire first bracket $42,350 x.15 = $6,353 28% of the amount in the second bracket ($60,200 - $42,350) x.28 = 4,970 Tax Liability $11,323 Average tax rate: $11,323/$60,200 = 18.8% Marginal tax rate = bracket rate = 28% TM 2-10 Slide 2 of 2

28. 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 TM 2-11Slide 1 of 2

29. Example 2-2 The Smith family (28% bracket) has a choice between an AT&T bond paying 11% and a Boston bond paying 9%. Solution: AT&T after tax = 11% x (1 –.28) = 7.92% < Boston = 9% Therefore prefer the Boston bond if risks are similar. If marginal tax rate is 15% 11%  (1 –.15) = 9.35% then prefer AT&T High bracket taxpayers tend to be more interested in tax exempt bonds than those with lower incomes. TM 2-11Slide 2 of 2

30. 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 income TM 2-12Slide 1 of 3

31. Income Rate 0 - $50,000 15% $50,000 - $75,000 25% $75,000 - $100,000 34% $100,000 - $335,000 39% $335,000 - $10,000,000 34% $10,000,000 - $15,000,000 35% $15,000,000 - $18,333,333 38% over $18,333,333 35% Table 2-5 Corporate Income Tax Schedule Notice the up and down rates. Is the system progressive? TM 2-12Slide 2 of 3

32. 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 $75,000. 3. 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 TM 2-12 Slide 3 of 3

33. Corporate Tax Examples Example 2-3 Tax for a corporation making EBT of $280,000 Solution: 50,000 .15 = $ 7,500 $25,000 .25 = 6,250 $25,000 .34 = 8,500 $180,000 .39 = 70,200 $92,450 TM 2-13 Slide 1 of 3

34. 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 .34 = $170,000 TM 2-13 Slide 2 of 3

35. 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 .34 = $3,400,000 $5,000,000 .35 = 1,750,000 $1,000,000 .38 = 380,000 $5,530,000 Over $18,333,333, calculate a flat 35% TM 2-13 Slide 3 of 3

36. 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 Tax @ 30% 30 36 EAT $ 70 $ 84 Dividends - 20 Net RE add $70 $ 64 TM 2-14 Slide 1 of 3

37. 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 shareholder Personal Tax Avoided by exempting dividends from one corporation to another Figure 2-2 Multiple Taxation TM 2-14 Slide 2 of 3 Corporation B Corporation A Shareholder

38. DIVIDENDS PAID TO CORPORATIONS Ownership Exemption <20% 70% 20% - 80% 80% >80% 100% TM 2-14 Slide 3 of 3

39. TAX LOSS CARRY BACK AND CARRY FORWARD YEAR 1 2 3 4 Total EBT $100 $100 ($250) $100 $50 Tax (30%) 30 30 - 30 90 EAT $ 70 $ 70 ($250) $ 70 ($40) ($100) ($100) ($50) Adjusted EBT $ 0 $ 0 $ 0 $ 50 $50 Tax 0 0 0 15 15 EAT $ 0 $ 0 $ 0 $ 35 $35 Figure 2-3 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. TM 2-15