22Chapt
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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
© 2006 by Nelson, a division of Thomson Canada Limited 3
Chapter 2 – Outline (2)
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 4
Chapter 2 – Outline (3)
Corporate Taxes How Much Tax Will a Corporation Pay? Corporate Tax Rates Effect of Corporate Taxes Corporate Taxes and Financing
© 2006 by Nelson, a division of Thomson Canada Limited 5
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
© 2006 by Nelson, a division of Thomson Canada Limited 6
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
© 2006 by Nelson, a division of Thomson Canada Limited 7
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
© 2006 by Nelson, a division of Thomson Canada Limited 8
Table 2.1: The Income Statement
© 2006 by Nelson, a division of Thomson Canada Limited 9
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
© 2006 by Nelson, a division of Thomson Canada Limited 10
The Income Statement (2)
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 11
The Income Statement (3)
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 12
The Income Statement (4)
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 13
Table 2.2: The Balance Sheet
© 2006 by Nelson, a division of Thomson Canada Limited 14
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
© 2006 by Nelson, a division of Thomson Canada Limited 15
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
© 2006 by Nelson, a division of Thomson Canada Limited 16
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
© 2006 by Nelson, a division of Thomson Canada Limited 17
The Balance Sheet—Assets (2)
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 18
The Balance Sheet—Assets (3)
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 19
The Balance Sheet—Assets (4)
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 20
The Balance Sheet—Assets (5)
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 21
The Balance Sheet—Assets (6)
• Capital Assets Predominant item includes property, plant
and equipment (PPE)
‘Capital’ implies long-lived—useful life of at least one year
© 2006 by Nelson, a division of Thomson Canada Limited 22
The Balance Sheet—Assets (7)
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 23
Table 2.3: Capital Asset Amortization
© 2006 by Nelson, a division of Thomson Canada Limited 24
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
© 2006 by Nelson, a division of Thomson Canada Limited 25
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
© 2006 by Nelson, a division of Thomson Canada Limited 26
The Balance Sheet—Liabilities (2)
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 27
The Balance Sheet—Liabilities (3)
• Accruals Expenses and liabilities for incomplete
transactions at end of accounting period Common examples—unpaid wages, interest,
taxes
© 2006 by Nelson, a division of Thomson Canada Limited 28
The Balance Sheet—Liabilities (4)
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 29
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
© 2006 by Nelson, a division of Thomson Canada Limited 30
The Balance Sheet—Equity (2)
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 31
The Balance Sheet—Equity (3)
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 32
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
© 2006 by Nelson, a division of Thomson Canada Limited 33
The Statement of Cash Flows
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 34
The Statement of Cash Flows
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 35
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.
© 2006 by Nelson, a division of Thomson Canada Limited 36
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.
© 2006 by Nelson, a division of Thomson Canada Limited 37
Constructing the Statement of Cash Flows—Example
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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© 2006 by Nelson, a division of Thomson Canada Limited 38
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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© 2006 by Nelson, a division of Thomson Canada Limited 39
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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© 2006 by Nelson, a division of Thomson Canada Limited 40
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
© 2006 by Nelson, a division of Thomson Canada Limited 41
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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© 2006 by Nelson, a division of Thomson Canada Limited 42
Constructing the Statement of Cash Flows—Example
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
Exa
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© 2006 by Nelson, a division of Thomson Canada Limited 43
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
© 2006 by Nelson, a division of Thomson Canada Limited 44
Income Taxes
• Authorities and Tax Bases In Canada income tax is levied on both
individuals and corporations
There are two taxing levels Federal Provincial
© 2006 by Nelson, a division of Thomson Canada Limited 45
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
© 2006 by Nelson, a division of Thomson Canada Limited 46
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
© 2006 by Nelson, a division of Thomson Canada Limited 47
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
© 2006 by Nelson, a division of Thomson Canada Limited 48
Table 2.4: Combined Personal Tax Brackets and Tax Rates, 2003
© 2006 by Nelson, a division of Thomson Canada Limited 49
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
© 2006 by Nelson, a division of Thomson Canada Limited 50
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
© 2006 by Nelson, a division of Thomson Canada Limited 51
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 $
© 2006 by Nelson, a division of Thomson Canada Limited 52
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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© 2006 by Nelson, a division of Thomson Canada Limited 53
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
© 2006 by Nelson, a division of Thomson Canada Limited 54
Table 2.5: Taxes on Interest, Dividend, and Capital Gains
Income, 2003
© 2006 by Nelson, a division of Thomson Canada Limited 55
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
© 2006 by Nelson, a division of Thomson Canada Limited 56
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.
© 2006 by Nelson, a division of Thomson Canada Limited 57
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
© 2006 by Nelson, a division of Thomson Canada Limited 58
How Much Tax Will A Corporation Pay?
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 59
How Much Tax Will A Corporation Pay?
• 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
© 2006 by Nelson, a division of Thomson Canada Limited 60
Table 2.6: Combined Corporate Tax Rates on Private Corporations with
Active Business Income
© 2006 by Nelson, a division of Thomson Canada Limited 61
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
© 2006 by Nelson, a division of Thomson Canada Limited 62
Table 2.7: Combined Corporate Tax Rates on Business Income (Corporations Other Than CCPCs), 2003
© 2006 by Nelson, a division of Thomson Canada Limited 63
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
© 2006 by Nelson, a division of Thomson Canada Limited 64
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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