Review of Accounting

1. Review of Accounting Chapter 4

2. Learning Objectives: • Use of the balance sheet, the income statement, and the statement of cash flows by managers. • Calculation of depreciation. • How depreciation affects cash flow. • How taxes affect a firm’s value. • Calculation of marginal and average tax rates.

3. The Firm’s Financial Statements • Annual report includes: • Income Statement • Balance Sheet • Statement of Cash Flows • Accompanying Notes

4. Income Statement ACME CORPORATION

5. The Firm’s Financial Statements • Annual report includes: • Balance Sheet

6. The Firm’s Financial Statements • Balance Sheet Assets = Liabilities + Owners’ Equity • Current Liabilities: • A/P • Accruals • S-T Debt • Long Term Liabilities: • Bonds • L-T Bank Debt • Mortgages • Preferred Stock • Owners’ Equity: • Common Stock • Capital in Excess • of Par • Retained Earnings • Current Assets: • Cash • Inventory • A/R • Fixed Assets: • Land • Plant • Equipment Less: Ac. Dep.

7. Balance Sheet ACME CORPORATION

8. Balance Sheet ACME CORPORATION December 31

9. Balance Sheet ACME CORPORATION Assets = Liabilities + Owner’s Equity

10. The Firm’s Financial Statements Income Statement: Revenues - Expenses = Net Income Sales Investment Income Gains Interest Received Dividends Received COGS Salaries Depreciation Exp. Taxes Other Expenses Interest Paid

11. The Firm’s Financial Statements Income Statement: Revenues - Expenses = Net Income Dividends Δ Retained Earnings

12. The Firm’s Financial Statements Annual report includes: Statement of Cash Flow

13. The Firm’s Financial Statements • Statement of Cash Flows Cash Inflow - Cash Outflow = Change in Cash From Operations: Cash Sales + Payments to Suppliers - Depreciation Exp. + Salaries - Collection of A/R + Increase A/R - Decrease inventory + Decrease Payables - Decrease Accruals -

14. The Firm’s Financial Statements • Statement of Cash Flows Cash Inflow - Cash Outflow = Change in Cash From Investing: Sale of Fixed Assets + Purchase of fixed assets - Purchase of other firms -

15. Statement of Cash Flows Cash Inflow - Cash Outflow = Change in Cash From Financing: Sale of stock + Buy back stock - Issue of LT debt + Repay LT debt - or notes payable + Pay dividends - Pay interest -

16. Market vs. Book Value Market Value & Book Value can be very different. Book Value is recorded initially at cost. Changes in book value (depreciation) follow specified accounting rules.

17. Market vs. Book Value • Factors that determine the disparity between market and book: • Time since acquisition • More time, more difference • Inflation: Higher inflation, more difference • Tangible versus intangible assets Intangible assets, more difference

18. Market vs. Book Value Liabilities As with assets, the market value of liabilities may diverge from the book value, but the relationship is less complex. The main factor that determines the difference between market and book values for liabilities of a healthy firm is: “the time until a liability must be paid off ” At maturity, the market value will equal the book value.

19. Market vs. Book Value of Equity Total Market Value of Equity is the market price per share times the number of shares outstanding. Book Value of equity reflects the changes in other asset and liability accounts since it is the account that can change to enforce the balance sheet identity. Stockholders’ Equity = Assets - Liabilities

20. DEPRECIATION • Accounting depreciation is the allocation of an asset’s initial cost over time. • Allowable depreciation expense is determined by established accounting rules.

21. CALCULATION OF DEPRECIATION • Depreciable basis • Total amount to be depreciated over the accounting life of the asset. • Equal to cost of the asset plus any setup and delivery costs incurred. • Straight line depreciation • Basis divided by accounting life with equal amounts of depreciation allocated to each time period (except for half-year convention). • MACRS (Modified Accelerated Cost Recovery System) • Specified percent charged each year.

22. Federal Income Taxation • Marginal and Average Tax Rates • Marginal = Tax Rate on the next dollar of income. • Average = Taxes paid divided by taxable income. Progressive Tax System • Average tax rate increases with the level of taxable income. • Marginal tax rate is greater than the average tax rate. (The current corp. tax rate schedule is not strictly progressive.)

23. THE TAX SYSTEM EXPLAINED IN COFFEE • Suppose that every day, ten men go out for COFFEE AND CONVERSATION • and the bill for all ten comes to $100... • If they paid their bill the way we pay our taxes, it would go something like this... • The first four men (the poorest) would pay nothing. • The fifth would pay $1. • The sixth would pay $3. • The seventh would pay $7. • The eighth would pay $12. • The ninth would pay $18. • The tenth man (the richest) would pay $59. The ten men drank COFFEE every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve ball. "Since you are all such good customers," he said, "I'm going to reduce the cost of your daily coffee bill by $20". Unlimited coffee for the ten men would now cost just $80. The group still wanted to pay their bill the way we pay our taxes. So the first four men were unaffected. They would still drink for free. But what about the other six men? How could they divide the $20 windfall so that everyone would get his fair share? They realized that $20 divided by six is $3.33. But if they subtracted that from everybody's share, then the fifth man and the sixth man would each end up being paid to drink THEIR COFFEE.

24. THE TAX SYSTEM EXPLAINED IN COFFEE So, the owner suggested that it would be fair to reduce each man's bill by a higher percentage the poorer he was, to follow the principle of the tax system they had been using, and he proceeded to work out the amounts he suggested that each should now pay. • At a bill of $80, in order to follow the principle of the tax system they had been using, and he proceeded to work out the amounts he suggested that each should now pay. • Now, the first four men along with the fifth would pay nothing. • The sixth now paid $2 instead of $3 (33% saving). • The seventh now paid $5 instead of $7 (28% saving). • The eighth now paid $9 instead of $12 (25% saving). • The ninth now paid $14 instead of $18 (22% saving). • The tenth now paid $49 instead of $59 (16% saving).

25. THE TAX SYSTEM EXPLAINED IN COFFEE Each of the six was better off than before. And the first four continued to drink for free. But, once outside the bar, the men began to compare their savings. "I only got a dollar out of the $20 saving," declared the sixth man. He pointed to the tenth man AND SAID, "but he got $10!“ "Yeah, that's right," exclaimed the fifth man. "I only saved a dollar too. It's unfair that he got ten times more benefit than me!“ "That's true!" shouted the seventh man. "Why should he get $10 back, when I got only $2? The wealthy get all the breaks!“ "Wait a minute," yelled the first four men in unison, "we didn't get anything at all. This new tax system exploits the poor!“ The nine men surrounded the tenth and beat him up. The next night the tenth man didn't show up for COFFEE AND CONVERSATION so the nine sat down and had their COFFEE without him. But when it came time to pay the bill, they discovered something VERY important. They didn't have enough money between all of them for even half of the bill!

26. THE TAX SYSTEM EXPLAINED IN COFFEE And that, my dear students is exactly how our tax system works. The people who already pay the highest taxes will naturally get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start drinking coffee overseas, where the atmosphere is somewhat friendlier. For those who understand this, no explanation is needed. For those who do not understand, no explanation is possible because you never will get it.

27. Income% of Total Income Tax Paid Top 1% 40% Top 10% 71% Top 50% 97% From 2009 IRS Data

28. Accounts Receivable TaxBuilding Permit TaxCDL License TaxCigarette TaxCorporate Income TaxDog License TaxFederal Income Tax Federal Unemployment Tax (FUTA) Fishing License Tax Food License Tax Fuel Permit Tax Gasoline Tax

29. Hunting License Tax Inheritance Tax Inventory Tax IRS Interest Charges (tax on top of tax) IRS Penalties (tax on top of tax) Liquor Tax Luxury Tax Marriage License Tax Medicare Tax Property Tax Real Estate Tax Service charge taxes

30. Social Security Tax Road Usage Tax (Truckers) Sales Taxes Recreational Vehicle TaxSchool   Tax  State   Income   Tax  State  Unemployment Tax (SUTA) Telephone Federal Excise Tax Telephone Federal Universal Service Fee Tax Telephone Federal, State and Local Surcharge Tax Telephone Minimum Usage Surcharge TaxTelephone Recurring and Non-recurring Charges Tax Telephone State and Local Tax Telephone Usage Charge Tax Utility Tax Vehicle License Registration Tax Vehicle Sales Tax Watercraft Registration Tax Well Permit Tax Workers Compensation Tax

31. Not one of these taxes existed 100 years ago...and our nation was the most prosperous in the world.We had absolutely no national debt... We had the largest middle class in the world... And there was only one wage-earner per family What happened?Can you spell 'politicians!'

32. Differential Tax Treatmentof Interest and Dividends Interest paid on corporate debt is a tax deductible expense. Dividends paid to common and preferred stockholders is not tax deductible. Dividends received by a corporation from another corporation have at least a 70% exclusion from taxable income.

33. Differential Tax Treatmentof Interest and Dividends $200 Dividend Income Corp “A”pays a $2/share dividend to shareholders. Corp “B”owns 100 shares of Common Stock in Corp “A” Corp “A” Corp “B” 70% or $140 is Tax Free 30% or $60 is Taxable Corp. “B” pays marginal tax rate of 25% Federal Taxes on dividend income $60 x .25 = $15

34. Who Pays all the Bills? The Taxpayer that’s Who (Just Us) Don’t forget Who pays the bills. Income% of Total Income Tax Paid Top 1% 40% Top 10% 71% Top 50% 97% From 2008 IRS Data

36. Homework Questions and Problems 1. Explain the difference between debt and equity. Why must the two equal total assets? 2. Ajax Inc. had profits of $200,000 for the year. Their retained earnings account grew from $800,000 at the beginning of the year to $950,000 by year end. How much did the firm pay out in dividends? 3. Calculate earnings per share for the following: Net income $500,000 Interest expense: $ 50,000 Common Dividends paid $100,000 Common shares outstanding 100,000 4. Working capital includes both current and non-current assets. Do you agree or disagree with this statement? Explain. 5. Explain why common stockholders are paid after preferred stockholders. 6. Are retained earnings and cash the same thing?

37. Analysis of Financial Statements Chapter 5

38. Learning Objectives • How financial ratio analysis helps managers assess the firm’s health. • Compute profitability, liquidity, debt, asset activity, and market value ratios. • Compare financial information over time and among companies.

39. Ratio Analysis • Financial managers use ratios to interpret the raw numbers on financial statements. • Relative measures allow comparison over time and to other firms. • Ratios are used by financial managers, other business managers, creditors, and investors.

40. Ratio Analysis • Profitability ratios • Liquidity ratios • Debt ratios • Asset activity ratios • Market value ratios Five Categories of Ratios

41. Ratio Analysis • Measure the overall effectiveness of the firm’s management. Profitability Ratios

42. Gross Profit Sales Gross Profit Margin = Ratio Analysis Profitability Ratios How effective is the firm at generating revenue in excess of its cost of goods sold?

43. Gross Profit = Margin Gross Profit Sales $575 $1,450 Gross Profit Margin = = 39.7% Balance Sheet Excalibur Corporation Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Net Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

44. Operating Income Sales Operating Profit Margin = Ratio Analysis Profitability Ratios How effective is the firm in keeping costs of production low?

45. Operating Profit = Margin Operating Income Sales $330 $1,450 Oper. Profit Margin = = 22.8% Balance Sheet Excalibur Corporation Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

46. Net Income Sales Net Profit Margin = Ratio Analysis Profitability Ratios Note: Net Income equals Earnings Available to CS when there is no preferred stock. How much net profit is being generated from each dollar of sales?

47. Net Profit = Margin Net Income Sales $162 $1,450 Net Profit Margin = = 11.2% Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

48. Net Income Total Assets Return on Assets = Ratio Analysis Profitability Ratios How effectively is the firm generating net income from its assets ?

49. Net Income Total Assets Return on Assets = $162 $2,530 = 6.4% ROA = Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40) 108 Net Income% $162 Common Dividends Paid 100 Addition to Retained Earnings $62

50. Net Income Common Equity Return on Equity = Ratio Analysis Profitability Ratios How well is the firm generating return to its equity providers?