Financial Background: A Review of Accounting, Financial Statements, and Taxes
-
Upload
tamesis-tanith -
Category
Documents
-
view
26 -
download
0
description
Transcript of Financial Background: A Review of Accounting, Financial Statements, and Taxes
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
Progressive Tax Systems, Marginal and Average Rates--Example
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.
Exa
mpl
e
25%Over $15,000
15%$5,000 - $15,000
10%0 - $5,000
Tax RateBracket
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
Personal Taxes—Example 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?
Exa
mpl
e
600Dividends from General Motors
1,200Interest on Boston bonds
800Interest on IBM bonds
2,000Interest on savings account
42,000 Sue
$45,000 Joe
Salaries
39
Personal Taxes—Example 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.
Exa
mpl
e
40
Personal Taxes—Example 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%.
Exa
mpl
e
$9,556Tax liability
$3,038
27% of the amount in the third bracket ($58,700 - $47,450) x .27
$5,318
15% of the amount in the second bracket ($47,450 - $12,000) x .15
$1,200
10% of the entire first bracket $12,000 x 0.10
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
Corporate Taxes—Example 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:
Exa
mpl
e
$92,450
Total
$70,200
$180,000 x .39
$8,500$25,000 x .34
$6,250$25,000 x .25
$7,500$50,000 x .15
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