Financial Background: A Review of Accounting, Financial Statements, and Taxes

1. Financial Background: A Review of Accounting, Financial Statements, and Taxes Chapter 2

2. The Nature of Financial Statements • Financial statements are numerical representations of a firm’s activities for an accounting period • Provide a picture of what is happening within the firm and between the firm and the rest of the world

3. The Nature of Financial Statements • Is Income “Income”? • Net income does not represent the cash a firm has in its pocket • Two major differences between cash and net income are • Accounts receivable—when a credit sale has occurred income is generated but cash is not received until the accounts receivable is paid • Depreciation—is the prorating of an asset’s cost over its service life • (also inventory or goods in process)

4. The Nature of Financial Statements • The Three Financial Statements • Income statement • Balance sheet • Statement of cash flows • Generated from the income statement and balance sheet

5. The Accounting System • A firm’s financial books are a collection of records in which money transactions are recorded • They are separated into a series of ‘accounts’ • Transactions include activities such as • Selling product • Buying inventory • Paying wages • Borrowing money • Each transaction is recorded by an entry into the books

6. The Accounting System • The Double Entry System • Each entry has two parts—with each side being made to a different account • The entry must balance • For example, if we borrowed $1,000 to buy a machine, the entry would involve increasing an asset account by $1,000 and increasing a liability account by $1,000

7. The Accounting System • Accounting Periods and Closing the Books • Books are closed by updating the period’s transactions in the accounting system and creating financial statements • Implications • Last period’s statements don’t say anything about what WILL happen next year • However, they can be used to predict what might happen • Stocks and Flows • The income statement reflects flows of money over a period of time • The balance sheet represents stocks of money at a point in time

8. The Income Statement • Sales (AKA: revenue) • Total receipts from selling goods from normal business operations • If the firm receives money from activities outside normal business operations, it will be recorded as other income • Cost and Expense • Both represent money spent to do business • Costs of Goods Sold—represent money spent on items closely related to the production of the product being sold • For instance, in a retail business, it represents the wholesale cost of the product • Expense—represent spending on an item that isn’t necessarily closely related to production, such as marketing or research

9. The Income Statement • Gross Margin • Represents sales revenue less cost of goods sold • 1st Fundamental measure of profitability • Interest and Earnings Before Interest and Taxes • Interest—the price the firm pays for borrowing money • Earnings before interest and taxes (EBIT)—a business’s profit before consideration of financing charges • AKA operating profit • Helps judge the strength of business operations without considering the interest expense a leveraged firm pays

10. The Income Statement • Earnings Before Tax, and Tax • Earnings before taxes (EBT) represent gross margin less all expenses except taxes • Tax refers to income taxes on EBT • Doesn’t necessarily mean the tax actually due • Net Income • Represents the “bottom line”—calculated by subtracting tax from EBT • Belongs to the company’s owners and can be paid out as dividends or retained

11. The Balance Sheet • Shows where all the business’s money has come from and what it’s been used for • All the sources of money and all the uses must balance • A firm’s money sources include creditors and owners • Borrowing money from a creditor creates a liability

12. The Balance Sheet • Has two sides • Assets; liabilities and equity • Assets = liabilities + equity • AKA statement of financial position • The ease with which an asset becomes cash is referred to as liquidity • Both assets and liabilities are arranged in order of decreasing liquidity • For instance, current assets are listed first, with cash being the first current asset listed

13. The Balance Sheet—Assets • Cash • Money in checking accounts plus currency on hand • Marketable securities are liquid investments held instead of cash • Short-term, modest return, low risk • Used by larger companies • Accounts Receivable • Represent credit sales that have not yet been paid • Bad Debt Reserve: a small percentage of credit sales that will never be paid • Writing Off a Receivable: when a receivable is known to be uncollectable, the balance in accounts receivable is reduced by that amount

14. The Balance Sheet—Assets • Inventory • Product held for sale in the normal course of business • Manufacturing firms will have raw materials, work-in-process and finished goods • Work-In-Process Inventories: as inventory moves through the production process, value added by the process is included in the inventory balance sheet amount • The Inventory Reserve: some inventory may be unusable; thus inventory balances are usually reported net of a reserve • Similar to bad debts expense associated with accounts receivable • Writing Off Bad Inventory

15. The Balance Sheet—Assets • Overstatements • Overstatement of accounts receivable and inventory can be a significant problem to users of financial statements • If these accounts are overstated the firm’s value is less than what is being reported • Can also mean firm is not managed efficiently

16. The Balance Sheet—Assets • Current Assets • Assets that can be expected to become cash within one year • Include cash, accounts receivable and inventory • All the money received from normal business operations flows through these accounts

17. The Balance Sheet—Assets • Fixed Assets • Predominant item includes property, plant and equipment (PPE) • ‘Fixed’ means long-lived—useful life of at least a year • Depreciation • An artificial accounting device that spreads the cost of an asset over its estimated useful life according to the matching principle • Sometimes depreciation can be front-loaded using an accelerated depreciation method • Financial Statement Representation • Depreciation is accumulated over an asset’s life; thus fixed assets can be represented NET of accumulated depreciation

18. The Balance Sheet—Assets • Fixed Assets • Disposing of a Used Asset • An asset may be salable at a value more or less than the net asset value on the books • A gain (loss) on disposal is taxed (tax deductible) • The Life Estimate • An asset remaining in use beyond its depreciated life is said to be fully depreciated • Tax Depreciation and Tax Books • Government allows businesses to use two sets of books • Tax books are those generated according to the tax rules (usually result in lower taxable income and lower taxes) • Books used for financial reporting purposes usually report higher profits due to differing depreciation method • Difference in taxes is placed in a deferred tax account on the financial books

19. The Balance Sheet—Liabilities • Represent what the company owes to creditors • Accounts payable • Represent what the firm owes when vendors deliver product without demanding immediate payment • Usually arises with the purchase of inventory • Terms of Sale • The length of time allowed until payment is due on a credit sale • Common terms involve payment within 30 days with a discount (such as 2%) for payment within a shorter time period—stated as 2/10, n/30, for instance • Delaying payment is known as stretching payables or leaning on the trade • Abuse of vendor’s terms may result in revocation of credit privileges

20. The Balance Sheet—Liabilities • Accruals • Used to recognize expenses and liabilities for incomplete transactions • A Payroll Accrual Example • Assume an employer pays its employees every Friday afternoon for working during the week • If the last day of the month falls on a Wednesday and the books have to be closed, two things arise • First, employees have worked through Wednesday and won’t be paid until Friday—this liability must be reflected on the balance sheet • Second, the work that went into that month should be reflected in that month’s costs and expenses • The solution is a month-end accrual representing the amount of the three days’ wages

21. The Balance Sheet—Liabilities • Current Liabilities • Items requiring payment within one year, such as Accounts Payable, Accruals, Notes Payable, etc. • Working Capital • Collectively current assets are known as gross working capital • Net working capital = current assets – current liabilities

22. The Balance Sheet—Liabilities • Long-Term Debt • Typically the most significant non-current liability • Usually consists of bonds and long-term loans • Leverage • The use of debt as a source of funds • If things are going well, the use of leverage can enhance the return on an entrepreneur’s own investment • Fixed Financial Charges • Borrowing money costs money in the form of interest • Interest charges are fixed • If the business does poorly, it still owes the same amount of interest it would have had it performed well • Many businesses have gone bankrupt due to their inability to pay fixed financial obligations

23. The Balance Sheet—Equity • Represents funds supplied to businesses by their owners either through • Direct investment or • Retained earnings • The Representation of Direct Investment by Owners • Represent the total amount of money paid for an issue of stock • Common stock account represents an arbitrary par value amount on the books • Paid in excess account represents the amount paid over the par value

24. The Balance Sheet—Equity • Retained Earnings • A company’s profits can be paid to its owners (generally through dividends) or retained • Money retained for reinvestment still belongs to the owners • Does not represent a reserve of cash • Shows all the earnings ever retained by the firm

25. The Balance Sheet—Equity • The Relationship Between Net Income and Retained Earnings • 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 + stock = ending equity

26. The Balance Sheet—Equity • Preferred Stock • A cross between debt and common equity, a hybrid • Legally it’s classified as equity • Total Capital • The sum of long-term debt and equity • Generally used to finance long-term assets • Total Liabilities and Equity • Sum of the right-hand side of the balance sheet • Must always equal total assets

27. Taxing Authorities and Tax Bases • In the U.S. there are typically three taxing levels • Federal • State • Local

28. Taxing Authorities and Tax Bases • A tax base is the item that is taxed, usually • Income Tax • An individual (or corporation) pays a fraction of income in a particular time period to the taxing authority • Wealth Tax • Based on the value of certain types of assets, such as real estate • Consumption Tax • Based on the amount of certain goods we use, such as a sales tax

29. Income Taxes—The Total Effective Tax Rate • Total effective tax rate (TETR) is the combined rate to which the taxpayer is subject • State tax is deductible from income in the calculation of federal tax • Can be calculated as • TETR = Tfederal tax rate + Tstate tax rate(1 – Tfederal tax rate) • For example, if a taxpayer is subject to a 30% federal tax rate and a 10% state tax rate, the TETR is • 30% + 10%(1 – 30%) = 37%

30. Progressive Tax Systems, Marginal and Average Rates • A progressive tax system is characterized by higher tax rates on incrementally higher income • Example: U.S. federal income tax system • A tax bracket is a range of income in which the tax rate is constant • A marginal tax rate is the rate that will be paid on the next dollar of income a taxpayer earns • An average tax rate is the percentage of total income a person pays in taxes

31. Q: Given the following tax brackets, calculate the total taxes (in dollars) a taxpayer earning $11,000 will pay. Also calculate the marginal and average tax rates. A: Since the taxpayer earned above $5,000 (but less than $15,000) she will pay two different tax rates. The first $5,000 will be taxed at 10%, so she will owe $500 on that amount. However, she earned an additional $6,000 which will be taxed at the 15% tax rate, for a tax of $900. Thus, her total tax in dollars is $500 + $900, or $1,400. Her marginal tax rate is 15%, or what she would pay in taxes on the next dollar of income. Her average tax rate is 12.7%, or $1,400  $11,000. Bracket Tax Rate 0 - $5,000 10% $5,000 - $15,000 15% Over $15,000 25% Example Progressive Tax Systems, Marginal and Average Rates--Example

32. Capital Gains and Losses • Ordinary income includes wages, business profits, dividends and interest • Since business profits can be positive or negative, ordinary income can also be an ordinary loss • Capital gain (loss) income arises when an asset that’s held for investment is sold for more (less) than was paid for it

33. Capital Gains and Losses • The Tax Treatment of Capital Gains and Losses • Historically capital gains have been taxed at lower rates than ordinary income in order to encourage investment • Short-term capital gains are not eligible for favorable tax treatment • Gains on assets held for more than one year qualify for long-term treatment and the tax rate is capped at 20% for individuals • Can represent a considerable savings since the top personal tax bracket is 38.6% • Capital losses can be used to offset capital gains • Corporations do not receive favorable rates on capital gains

34. Income Tax Calculations • Income taxes are paid by both people and corporations according to the same basic principles • Tax is levied on a base of taxable income • Gross income less certain deductions • Rate schedules for corporations and people are very different as are the rules for calculating taxable income

35. Personal Taxes • In 2001 Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 • Purpose was to stimulate economy by lowering personal tax rates gradually over five years • Taxes on people are called personal or individual taxes • Separate schedules exist for single individuals, married couples filing jointly, married people filing separately and certain heads of household • Rate schedules are adjusted for inflation annually

36. Table 2.4

37. Personal Taxes • Taxable Income • Some income items are exempt from taxation, including interest on municipal bonds • Taxable income is total non-exempt income less exemptions and deductions • Deductions are personal expenditures that the tax code allows to be subtracted before calculating taxes owed • Exemptions are fixed amounts that can be deducted to arrive at taxable income

38. Q: The Smith family had the following income in 2003: During 2003 they sold an investment property for $50,000 that they had purchased three years earlier for $53,000. They also sold some AT&T stock for $14,000 for which they had paid $12,000 five years before. They paid $12,000 interest on their home mortgage and $1,800 in real estate taxes. State income tax of $3,500 was withheld from their paychecks during the year. They contributed $1,200 to their church. They have two children living at home. Assume the exemption rate is $3,050 per person. What is their taxable income and their tax liability? Further, what are their marginal and average tax rates using the tax rates for the married, filing jointly column in Table 2.4? Salaries Joe $45,000 Sue 42,000 Interest on savings account 2,000 Interest on IBM bonds 800 Interest on Boston bonds 1,200 Example Dividends from General Motors 600 Personal Taxes—Example

39. A: The income on the Boston bonds is exempt from taxation; thus their taxable income is $90,400, including salaries, interest and dividend income. They had a capital loss on their investment property of $3,000 and a capital gain of $2,000 on the sale of stock. Thus they have a net capital loss of $1,000. Since this is less than $3,000 it can be used in its entirety to offset ordinary income. Therefore their total income is $89,400 or $90,400 - $1,000. Their deductions total $18,500 and include mortgage interest of $12,000, state and real estate taxes of $5,300 and a charitable deduction of $1,200. They also have exemptions totaling $12,200, or $3,050 x 4. Their taxable income is their total income less total deductions and total exemptions, or $58,700. Example Personal Taxes—Example

40. A: Their tax liability is as follows: Their average tax rate is 16.3%, or $9,556  $58,700 while their marginal tax rate is 27%. 10% of the entire first bracket $12,000 x 0.10 $1,200 15% of the amount in the second bracket ($47,450 - $12,000) x .15 $5,318 Example 27% of the amount in the third bracket ($58,700 - $47,450) x .27 $3,038 Tax liability $9,556 Personal Taxes—Example

41. Personal Taxes • Tax Rates and Investment Decisions • When comparing investments in municipal bonds (muni) vs. corporate bonds, an adjustment must be made due to the fact that interest on municipal bonds are not taxed • If a muni is paying 8% and a corporate bond of the same risk level is also paying 8%, the muni is a better deal after considering taxes • However, if the rates differ, the corporate bond must be adjusted to be after tax • Multiply by (1 – marginal tax rate)

42. Corporate Taxes • Are similar in principle to personal taxes • Total income is the business’s revenue • Deductions are the charges and expenditures required to run the company • Exemptions are not allowed • A company’s Earnings Before Tax (EBT) represent a corporation’s taxable income • Corporate tax rates do not consistently rise as taxable income rises • With personal taxes taxpayers pay a lower rate on income in the bottom brackets • However, corporate tax tables are fixed so that corporations generating high incomes pay a constant rate on all their income

43. Table 2.5

44. Q: Calculate, using the corporate tax rates in Table 2.5, the tax liability for a corporation making EBT of $280,000. A: Applying the corporate tax table results in the following tax liability: $50,000 x .15 $7,500 Example $25,000 x .25 $6,250 $25,000 x .34 $8,500 $180,000 x .39 $70,200 Total $92,450 Corporate Taxes—Example

45. Corporate Taxes • Taxes and Financing • The corporate tax system favors debt financing over equity financing • Interest payments made to debt investors are tax deductible • Dividend payments to equity investors are not tax deductible • If, for example, two companies generated the same EBT, but one firm were financed entirely with debt, the firm with debt financing would have a lower tax liability

46. Corporate Taxes • Dividends Paid to Corporations • Dividends paid to another corporation are partially tax exempt • The percentage of dividends deductible by the receiving corporation depends on the percentage ownership that corporation has of the dividend-paying corporation • Tax Loss Carry Back and Carry Forward • Business losses can be carried backward or forward in time to offset taxes