2 2 Chapter Review of Accounting, Financial Statements, and Income Taxes Slides Developed by: Terry...

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Chapt

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Review of Accounting, Financial Statements, and

Income Taxes

Review of Accounting, Financial Statements, and

Income Taxes

Slides Developed by:

Terry FegartySeneca College

© 2006 by Nelson, a division of Thomson Canada Limited 2

Chapter 2 – Outline (1)

• Accounting Systems and Financial Statements The Nature of Financial Statements Accounting Periods

• The Income Statement• The Balance Sheet

The Balance Sheet—Assets Tax Amortization and Tax Books The Balance Sheet—Liabilities The Balance Sheet—Equity

• The Statement of Cash Flows Constructing the Statement of Cash Flows Free Cash Flows



• Income Taxes Income Tax Authorities and Tax Bases Income Tax Formulas Income Tax Calculations Progressive Tax System, Marginal and

Average Rates Personal Tax on Investment Income Tax Rates and Investment Decisions Capital Gains and Losses Tax on Dividends



Corporate Taxes How Much Tax Will a Corporation Pay? Corporate Tax Rates Effect of Corporate Taxes Corporate Taxes and Financing


The Nature of Financial Statements

• Financial statements are numerical representations of a firm’s activities for an accounting period Provide picture of what’s happening within

firm and between firm and rest of the world


The Nature of Financial Statements

• The Three Financial Statements Income statement Balance sheet Statement of cash flows

• Financial statements are associated with particular accounting periods usually months, quarters, and years—during

which accounting system accumulates transactions


Financial Statements and Accounting Periods• The income statement

reports revenue earned and costs and expenses incurred over accounting period. The difference is profit

• The balance sheet reports that, at end of accounting period, company

owns certain assets and owes certain liabilities, Difference is owners’ equity

• The statement of cash flows reports cash receipts and cash disbursements

over accounting period. Difference is net cash flow


Table 2.1: The Income Statement


The Income Statement (1)

• Sales (AKA: revenue) Total receipts from selling goods from normal

business operations• If firm receives money from activities outside normal

business operations, it will be recorded as other income

• Cost of Goods Sold Represents money spent on items related to

production or purchase of product being sold• For instance, in retail business, represents wholesale cost

of product



• Gross Margin Represents Sales revenue less Cost of goods sold

• Fundamental measure of profitability

• Expenses Represent spending on items that are not closely

related to production, such as marketing or accounting

• Both Expenses and Cost of goods sold may include amortization



• Earnings Before Interest and Taxes (EBIT) Business’s profit before financing charges

• AKA: Operating profit• Helps judge strength of business operations without

considering interest expense on debt

• Interest Expense Price firm pays for borrowing money

• Earnings Before Tax (EBT) Represent Gross margin less all expenses except

taxes



• Tax refers to income taxes on EBT

• Doesn’t necessarily mean tax actually due

• Net Income Represents “bottom line”—calculated by

subtracting tax from EBT• AKA: Earnings after Tax (EAT)

Belongs to company’s owners and can be paid out as dividends or retained by company


Table 2.2: The Balance Sheet


The Balance Sheet

• Shows where business’s money has come from and what it’s been used for All sources of money and all uses must

balance• Money sources include creditors and

owners Borrowing money from creditor creates

liability• Has two sides

Assets (=) liabilities + equity


The Balance Sheet

• Liquidity—ease with which an asset becomes cash Assets and liabilities are arranged in order of

decreasing liquidity• For instance, current assets are listed first, with

cash being first current asset listed


The Balance Sheet—Assets (1)

• Current Assets Assets that can be expected to become cash

within one year Include Cash, Accounts receivable and

Inventory All money received from normal business

operations flows through current accounts



• Cash Money in chequing accounts plus currency on

hand Marketable securities or cash

equivalents—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•Allowance for doubtful accounts: provision for

credit sales that will never be paid

•Writing off a receivable: when receivable is known to be uncollectible, accounts receivable reduced by that amount



• Inventory Product held for sale in normal course of

business• Manufacturing firms will have raw materials,

work-in-process and finished goods• The inventory allowance: inventory balances

are usually reported net of an allowance for unusable inventory

•Writing off bad inventory: when inventory is identified as missing, damaged, or obsolete, balance sheet inventory account reduced to reflect the loss



• Overstatements Overstatement of accounts receivable and

inventory can be significant problem to users of financial statements

If these accounts are overstated, firm’s value and net income are less than what are being reported

Can also mean firm is not managed efficiently



• Capital Assets Predominant item includes property, plant

and equipment (PPE)

‘Capital’ implies long-lived—useful life of at least one year



• Capital Assets—Amortization Accounting procedure that spreads cost of

capital asset over its estimated useful life Asset remaining in use beyond its amortized

life is said to be fully amortized Sometimes amortization can be front-loaded

using an accelerated amortization method Balance Sheet Presentation

• Capital assets presented net of accumulated amortization


Table 2.3: Capital Asset Amortization


Tax Amortization and Tax Books

• Government allows businesses to use two sets of books Tax books—generated according to the tax

rules (usually result in lower taxable income and lower taxes)

Financial books—used for financial reporting purposes• Usually report higher profits due to differing

amortization method Difference in taxes is placed in deferred tax

account on financial books


The Balance Sheet—Liabilities (1)

• Represent what company owes to creditors

• Current Liabilities Items requiring payment within one year, such as

Accounts payable, Accruals, Notes payable, etc.

• Working Capital Total current assets—known as gross working

capital Net working capital = Current assets – Current

liabilities



• Accounts payable What firm owes when it buys from vendors on credit

(called trade credit)• Usually arises with purchase of inventory

Terms of Sale• Length of time allowed until payment is due on credit sale• May include discount for early payment• 2/10, n/30, for instance

Delaying payment—known as stretching payables or leaning on the trade

• Abuse of vendor’s terms may result in cancellation of credit privileges



• Accruals Expenses and liabilities for incomplete

transactions at end of accounting period Common examples—unpaid wages, interest,

taxes



• Long-term Debt Usually consists of bonds and long-term loans Leverage

• Use of debt as a source of funds• If things are going well, leverage can improve return on

owner’s investment

Fixed Financial Charges• Interest charges on debt are fixed• If business performs well or poorly, owes same amount of

interest• Many businesses have gone bankrupt due to inability to pay

fixed financial obligations


The Balance Sheet—Equity (1)

• Funds supplied to business corporations by their shareholders either through Direct investment or Retained earnings

• Direct Investment by Shareholders Total amount of money paid for an issue of shares

• Common shares • Common shareholders own the corporation

• Preferred shares • A cross between debt and common shares



• Retained Earnings Company’s profits can be paid to its

shareholders (generally through dividends) or retained in the business• Money retained for reinvestment still belongs to

owners

Does not represent a cash balance

Shows all the earnings ever retained by the firm



• The Relationship Between Net Income and Equity 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 + new

shares issued = ending equity


The Statement of Cash Flows

• Income does not represent cash in firm’s bank account

• The Statement of Cash Flows provides info on movement of cash in and out of company

• Constructed from Balance Sheet and Income Statement



• Cash Flow Rules To construct a statement of cash flows

• Cash income cash inflow• Cash loss cash outflow• Asset increase cash outflow• Asset decrease cash inflow• Liability increase cash inflow• Liability decrease cash outflow• Equity increase cash inflow• Equity decrease cash outflow



• Statement of Cash Flows is organized to show Operating activities

• Running business on day-to-day basis Investing activities

• When firm buys or sells things to do business• Includes purchases and sales of long-term financial

assets

Financing activities• When firm borrows money, pays off loans, sells

shares or pays dividends


Constructing the Statement of Cash Flows—Example

Belfry Company Belfry CompanyBalance Sheet Income StatementAs of 31/12/X2 For the period ending 31/12/X2

Sales 10,000$ 31/12/X1 31/12/X2 COGS 6,000

Cash 1,000$ 1,400$ Gross margin 4,000$ Accounts receivable 3,000 2,900 Expenses 1,600$ Inventory 2,000 3,200 Amortization 500 CURRENT ASSETS 6,000$ 7,500$ EBIT 1,900$ Capital assets Interest 400 Gross 4,000$ 6,000$ EBT 1,500$ Accumulated amortization -1,000 -1,500 Tax 500 Net 3,000$ 4,500$ Net Income 1,000$ TOTAL ASSETS 9,000$ 12,000$

Accounts payable 1,500$ 2,100$ Accruals 500 400CURRENT LIABILITIES 2,000$ 2,500$ Long-term debt 5,000$ 6,200$ Equity 2,000$ 3,300$ TOTAL LIABILITIES AND EQUITY 9,000$ 12,000$

Assets

Liabilities and Equity

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Also assume firm paid a $500 dividend and sold shares for $800

during the year.


Constructing the Statement of Cash Flows• Operating activities

Involve Income Statement and Balance Sheet current accounts

Involves activities firm does on day-to-day basis such as

• Buying inventory• Producing and selling product• Paying expenses and taxes• Collecting credit sales

Focus of activitiesis generating net

income—the beginning of a

cash flowstatement.



For Belfry, cash from operating activities is:

Net Income $1,000

+ Amortization $500

= Operating income $1,500

+ increase in receivables $100

- increase in inventory ($1,200)

+ increase in payables $600

- decrease in accruals ($100)

Cash from operating activities

$900

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Constructing the Statement of Cash Flows• Investing activities

Typically include purchasing Capital assets Examine the change in Gross Capital assets,

not Net• Because the net value includes adjustment for

amortization• Amortization has already been included under Operating

activities

For Belfry, cash from investing activities is• Purchase of capital assets ($2,000)

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Constructing the Statement of Cash Flows• Financing activities

Deal with long-term debt and equity For Belfry, cash from financing activities is:

Increase in long-term debtSale of shares

$1,200800

Dividend paid2,000(500)

Cash from financing activities $1,500

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Constructing the Statement of Cash Flows

• The Equity Accounts Changes in equity are already shown

elsewhere

• Net Income is included in Cash flows from operating activities

• Sale of shares and dividends are considered under Cash flows from financing activities


Constructing the Statement of Cash Flows• The Cash Account

Sum of cash flows from operating activities, financing activities and investing activities must equal the change in cash

For Belfry, change in cash balance is:

Beginning cash balance $1,000

Net cash flow 400

Ending cash balance $1,400

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While the firm was profitable it still had to borrow money and sell shares to finance the

increase in capital assets.

Belfry CompanyStatement of Cash FlowsFor the period ended 31/12/X2CASH FROM OPERATING ACTIVITIESNet incomeAmortizationNet changes in current accountsCash from operating activitiesCASH FROM INVESTING ACTIVITIESPurchase of capital assetsCASH FROM FINANCING ACTIVITIESIncrease in long-term debtSale of sharesDividend paidCash from financing activitiesNET CASH FLOW Beginning cash balance Net cash flow Ending cash balance

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Free Cash Flows

• Cash flows from operating activities Some may be used to maintain long-run competitive

position• Replace worn-out capital assets• Pay dividends

• Free cash flow (FCF) refers to cash generated beyond these needs Free cash flow =

• Cash flow from operating activities• Minus: Capital expenditures• Minus: Dividends


Income Taxes

• Authorities and Tax Bases In Canada income tax is levied on both

individuals and corporations

There are two taxing levels Federal Provincial


Income Tax Formulas

(1) Total income – Tax deductions = Taxable income

(2) Taxable income × Tax rates = Total tax

(3) Total tax – Tax credits = Net tax payable


Income Tax Calculations

• Income taxes are calculated on taxable income

• Income subject to tax less certain deductions

• Tax rates—combined rates levied by the federal and provincial governments on taxable income to determine tax payable

• Rate schedules for corporations and people are very different as are rules for calculating taxable income

• Tax credits may be available to reduce tax otherwise payable


Progressive Tax System, Marginal and Average Rates• Income tax system for individuals is

progressive Progressive tax system: higher tax rates on

higher income

Tax bracket: range of income in which tax rate is constant

Marginal tax rate: rate that will be paid on next dollar of income

Average tax rate: total taxes paid as a percentage of total income


Table 2.4: Combined Personal Tax Brackets and Tax Rates, 2003


Personal Taxes on Investment Income • Governments levy tax on various types of

personal income, including investment income interest from bonds dividends on shares capital gains from the sale of securities.

• Each type of investment income is taxed differently. Interest income is taxed at person’s marginal rate Tax on dividends is reduced by dividend tax

credits Only 50% of capital gains to subject to tax


Capital Gains and Losses

• Capital gain (loss) arises when long-term asset that’s held for investment is sold for more (less) than was paid for it

• Capital gains receive more favourable tax treatment than ordinary income in order to encourage investment Currently, only 50% of a capital gain is subject to tax Capital losses can be used to offset capital gains


Capital Gains and Losses

• Taxable capital gain: Proceeds on sale of the asset $ Less the cost of the asset $ Less the expenses to sell the asset $ Equals the capital gain $ Less the exempt portion – 50%

$ Equals the taxable capital gain $


Tax on Capital Gains—Example

Q. During the last tax year, Helen Zhou sold an investment property for $80,000 that she had purchased three years earlier for $53,000. She also sold some Nortel shares for $4,000 for which she had paid $12,000 two years before.

What is her taxable capital gain?A.

Gain on investment property $27,000 Loss on shares (8,000) Net capital gain $19,000

Taxable capital gain (50%) $9,500

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Tax on Dividends

• Dividends received from Canadian corporations also receive beneficial tax treatment

• Individual investors who receive such dividends are entitled to dividend tax credits, which reduce their effective tax rates on dividend income


Table 2.5: Taxes on Interest, Dividend, and Capital Gains

Income, 2003


Tax Rates and Investment Decisions

• Investors need to consider the different tax treatments in making investment decisions. It is after-tax, not before-tax, income that

counts. Corporations allow for these different tax

treatments when considering financing methods and distributions to their investors


Corporate Taxes

• A corporation is liable for Canadian corporation taxes if it was incorporated in Canada is managed from Canada or operates in Canada.

• A corporation must file both federal and provincial tax returns

• Income taxes on corporate profits can significantly reduce a corporation’s earnings and cash flow.


How Much Tax Will A Corporation Pay?

• Total income is business’s revenue

• Deductions are Cost of goods sold and expenses required to run the company

• A company’s Earnings before tax (EBT) represent corporation’s taxable income



• Adjustments to Corporate Income

Dividends Paid to Corporations• Dividends received from another corporation are

deductible by the receiving corporation

Tax Loss Carry Back and Carry Forward

• Business losses can be carried backward or forward in time to offset taxes



• Corporate tax rates do not rise consistently as taxable income rises Corporations generating high incomes pay a

constant rate on all their income Rate reductions for small private

corporations and manufacturing businesses

• Some corporate tax credits allowed


Table 2.6: Combined Corporate Tax Rates on Private Corporations with

Active Business Income


Corporate Taxes—Example

Q: Using the corporate tax rates in Table 2.6, calculate the tax liability for a private corporation (CCPC) making EBT of $330,000.

A: Applying the corporate tax table results in the following tax liability:

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70,100 Total

4,100$10,000 x 0.41

6,000$20,000 x 0.30

17,250$75,000 x 0.23

42,750$225,000 x 0.19


Table 2.7: Combined Corporate Tax Rates on Business Income (Corporations Other Than CCPCs), 2003


Effect of Corporate Taxes

• Taxes affect most financial transactions:

Dividend policy: capital gains versus dividend policy

Capital budgeting: return on investment

Leasing: motivated by tax effects

Capital structure policy: tax advantage of debt financing


Corporate Taxes and Financing

• Taxes and Financing The corporate tax system favors debt

financing over share financing Interest payments made to debt investors are

tax deductible• Dividend payments to equity investors are not tax

deductible If two companies generated the same EBT,

but one firm was financed entirely with debt, firm with debt financing would have lower tax liability

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