Review of Accounting

1. Review of Accounting Chapter 4 Sep 29, 2012

2. Learning Objectives: • Use of the balance sheet, the income statement, and the statement of cash flows • Prep for Fin’lStm’t Analysis • Depreciation, & affect on cash flow. • How taxes affect cash flow. • 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 Link to Annual Report Gallery

4. The Firm’s Financial Statements Income Statement (covers a period of time) Revenues - Expenses = Net Income Revenues Sales (95% of revenue) Other Income Gains Interest Received Dividends Received Royalties Expenses Cost of Goods Sold Salaries Selling & Admin Research & Develop. Depreciation Exp. Interest paid Taxes

5. The Firm’s Financial Statements Income Statement (period of time) Revenues - Expenses = Net Income (Loss) Close Books ΔRetained Earnings Dividends Paid

6. Income Statement ACME CORPORATION

7. The Firm’s Financial Statements • Annual report includes: • Income Statement • Balance Sheet • Statement of Cash Flows • Accompanying Notes Link to Annual Report Gallery

8. The Firm’s Financial Statements Assets = Liabilities + Owners’ Equity • Balance Sheet (as of a point in time) Current Assets Cash Inventory A/R Long Term Assets Land Plant Equipment Less: Depreciation Owners’ Equity Common Stock Capital in Excess of Par Retained Earnings Current Liabilities A/P Accruals Wages payable Long Term Liabilities Bonds L-T Bank Debt Mortgages

9. Balance Sheet ACME CORPORATION

10. Balance Sheet ACME CORPORATION December 31

11. Balance Sheet ACME CORPORATION December 31 Assets = Liabilities + Owner’s Equity

12. The Firm’s Financial Statements • Annual report includes: • Balance sheet • Income statement • Statement of cash flows • Accompanying notes Link to Annual Report Gallery

13. Statement of Cash Flow(covers a period of time) Reconciles Net Income on the accrual basis to the change in Cash Three parts: • Cash generated by operations • Cash used for investments • Cash from or used for Financing These parts will add up to the change in cash on the balance sheet

14. Statement of Cash Flow • Start with comparative balance sheets (see figure 4-5 on page 76) • Calculate year to year changes in each line item (see Changes column) • Indicate increase (+) or decrease (-) • These will be the numbers that go on the statement of cash flow • No totals or sub-totals!

15. Statement of Cash Flow • To determine whether the change in balance sheet increases or decreases cash flow, use the following table: • Asset increases + Cash decreases • Asset decreases - Cash increases • Liability increases + Cash increases • Liability decreases - Cash decreases

16. The Firm’s Financial Statements Cash Inflow - Cash Outflow = Change in Cash • Statement of Cash Flows, p.75) From Operations: Net Income 3,184 + Depreciation expense (non cash exp) 2,000 + Decr/-Incr Accounts Receivable (300) + Decr/-Incr Inventory 7,300 + Decr/-Incr other current assets 1,000 + Incr/-Decr Accounts Payable (3,000) + Incr/- Decr Accrued expenses (1,000) + Incr/- Decr other current liabilities 0 Cash from Operations 9,184

17. The Firm’s Financial Statements • Statement of Cash Flows, p. 75) Cash Inflow - Cash Outflow = Change in Cash From Investing: Sale of Fixed Assets 0 Purchase of fixed assets (14,000) Other purchases/sales of long term assets 0 Cash used for investments (14,000) • Note: Depreciation already accounted for in cash flow from operations

18. The Firm’s Financial Statements • Statement of Cash Flows (p. 75) Cash Inflow - Cash Outflow = Change in Cash From Financing: Sale of stock 4,000 Issue of LT debt 4,216 Buy back Pref stock (1,000) Repay ST/LT debt (1,000) Pay Dividends ( 400) Cash from Financing 5,816

19. Statement of Cash Flow(See page 75 in book) • Cash flow from Operations 9,184 • Cash flow used for investments (14,000) • Cash flow from Financing 5,816 Change in cash balance 1,000 Proof: Ending cash balance 12/31/09 10,000 Beginning cash bal 12/31/08 9,000 Change in cash 1,000

20. Market Book Value of Assets versus • Market Value & Book Value can be very different. Book Value – asset purchased is recorded initially at cost. Changes in book value (depreciation) follow specified accounting rules. Book value rarely considers what you can sell the asset for, i.e., a car, or a house

21. Market Book Value of Assets versus • Factors that determine the disparity between market and book: • Time since acquisition – value can go up or down (Time value of money) • Inflation Higher inflation, higher costs • Tangible versus intangible assets Intangible assets, i.e., good will (you pay more than market value)

22. Market Book Value of Liabilities versus • As with assets, the market value of long term liabilities may diverge from the book value, • The main factor that determines the difference between market and book values for liabilities of a healthy firm is: “the difference in the interest rates and the time until a liability must be paid off ”. • As interest rate goes up, value of debt goes down, and vice versa. (See/Saw)

23. Market Book Value of Equity versus Equity Value Total Market Value of Equityis the market price per share times the number of shares outstanding. Book Value of equity reflects the changes in the other asset and liability accounts. Stockholders’ Equity = Assets - Liabilities

24. Depreciation • Accounting depreciation is the allocation of an asset’s initial cost over time. Allowable depreciation expense is determined by established accounting rules. • Depreciable basis of an asset: 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.

25. Calculation of Depreciation • Straight line depreciation • Basis divided by accounting life with equal amounts of depreciation allocated to each time period • MACRS Depreciation Allowable by the IRS See table 4-1 on page 79

26. Straight Line Depreciation • Assume equipment purchased for $ 9,000 • Cost of delivery and installation was $1,000. • Accounting life = 3 years. • Total depreciable basis = $10,000 • (Depreciated over 4 years due to half year convention) YearPercentx BasisDepreciation 1 16.67 10,000 1,667 2 33.33 10,000 3,333 3 33.33 10,000 3,333 4 16.67 10,000 1,667

27. Example of MACRS Depreciation Assume equipment purchased for $ 9,000 and the cost of delivery and installation was $1,000. Accounting life = 3 years. Depreciated over 4 years due to the half-year convention. Total depreciable basis = $10,000. Three Year MACRS Schedule Year Percent X Basis Deduction 1 33.3% $10,000 $ 3,330 2 44.5% 4,450 3 14.8% 1,480 4 7.4% 740

28. Federal Income Taxation • Marginal = Tax Rate on the next dollar of income. Used when evaluating investment proposals. • Marginal Tax Rates Progressive Tax System • Average tax rate increases with the level of taxable income. See Table 4-2, page 80

29. 2009 Corporate Tax Rates Taxable Income Tax Rate $0 - $50,000 15% $50,001 - $75,000 25% $75,001 - $100,000 34% $100,001-$335,000 39% $335,001-$10,000,000 34% $10,000,001-$15,000,000 35% $15,000,001-$18,333,333 38% Over $18,333,333 35 Federal Income Taxation • Tax Computation

30. $45,650 Total Tax Liability Federal Income Taxation Tax Computation 2009 Corporate Tax Rates Example: Compute tax for a corporation with Taxable Income of $160,000 Taxable Income Tax Rate $0 - $50,000 15% $50,001 - $75,000 25% $75,001 - $100,000 34% $100,001-$335,000 39% 1st Bracket $50,000 x15% = $7,500 2nd Bracket $25,000 x25% = $6,250 3rd Bracket $25,000 x34% = $8,500 $60,000 x39% = $23,400 4th Bracket

31. Federal Income Tax Say taxable income is $335,000 • $50,000 x .15 = 7,500 • $25,000 x .25 = 6,250 • $25,000 x .34 = 8,500 • $235,000 x .39 = 91,650 Total tax = 113,900 Or, $335,000 x .34 = 113,900 Hint: Once taxable income is more than 335,000, up to 10,000,000, you can just use 34% as the tax rate

32. Average Tax Rate Tax LiabilityTaxable Income $45,650$160,000 = = = 28.5% 5% surcharge on: Taxable income $100,000--335,000 3% surcharge on: Taxable income $15M --18.333M Federal Income Taxation Tax Computation 2009 Corporate Tax Rates Example: Compute tax for a corporation with Taxable Income of $160,000 Taxable Income Tax Rate $0 - $50,000 15% $50,001 - $75,000 25% $75,001 - $100,000 34% $100,001-$335,000 39% Marginal tax rate = 39%

33. 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 (paid from retained earnings – already taxed!)