Description
Describe the basic purpose and components of the stockholder’s report. Review the format and key components of the income statement, the balance sheet, the statement of retained earnings, the statement of cash flows, and the procedures for consolidating international financial statements
Principals of
Managerial Finance
9th Edition
Chapter 3
Financial Statements, Taxes,
Depreciation, and Cash Flow
Learning Objectives
• Describe the basic purpose and components of the
stockholder’s report.
• Review the format and key components of the income
statement, the balance sheet, the statement of
retained earnings, the statement of cash flows, and
the procedures for consolidating international financial
statements.
• Understand the effect of depreciation and other non-
cash charges on the firm’s cash flows.
Learning Objectives
• Determine the depreciable value of an asset, its
depreciable life, and the amount of depreciation
allowed each year for tax purposes using the modified
accelerated cost recovery system (MACRS).
• Analyze the firm’s cash flows and develop and
interpret the statement of cash flows.
• Discuss the fundamentals of business taxation of
ordinary income and capital gains, and he treatment of
tax losses.
• The guidelines used to prepare and maintain financial
records and reports are known as generally accepted
accounting principles (GAAP).
• GAAP is authorized by the Financial Accounting
Standards Board (FASB).
• Public corporations with more than $5 million in assets
and more than 500 stockholders are required by the
SEC to provide heir stockholders with an annual
stockholders report.
The Stockholders’ Report
• The income statement provides a financial summary
of a company’s operating results during a specified
period.
• Although they are prepared annually for reporting
purposes, they are generally computed monthly by
management and quarterly for tax purposes.
Financial Statements
The Income Statement
Financial Statements
EBIT
?????
??
• The balance sheet presents a summary of a firm’s
financial position at a given point in time.
• Assets indicate what the firm owns, equity represents
the owners’ investment, and liabilities indicate what
the firm has borrowed.
Financial Statements
The Balance Sheet
Financial Statements
=raw material+work-in-process+finished goods
+100
+400
-100
-300
+300
+100
????
Financial Statements
??????
?????or????
+200
-100
-100
+200
+100
• The statement of retained earnings reconciles the net
income earned and dividends paid during the year,
with the change in retained earnings.
Financial Statements
Statement of Retained Earnings
Financial Statements
• The statement of cash flows provides a summary of
the cash flows over the period of concern, typically the
year just ended.
• This statement not only provides insight into a
company’s investment, financing and operating
activities, but also ties together the income statement
and previous and current balance sheets.
Financial Statements
Statement of Cash Flows
Financial Statements
• FASB 52 mandated that U.S. based companies
translate their foreign-currency denominated assets
and liabilities into dollars using the current rate
(translation) method.
• Under the translation method, companies translate
foreign-currency-denominated assets and liabilities
into dollars for consolidation with the parent
company’s financial statements.
• Income statement items are usually treated similarly,
although they can also be translated at the average
exchange rate during the period (year).
Consolidating International Financial Statements
?????
• Equity accounts, on the other hand, are translated into
dollars by using the exchange rate that prevailed when
the parent’s equity investment was made (the
historical rate).
• Retained earnings are adjusted to reflect each year’s
operating profits (or losses), but does not consider any
profits or losses resulting from currency changes.
• Instead, translation gains and losses are accumulated
in an equity reserve account called the cumulative
translation adjustment.
Consolidating International Financial Statements
See an example on p.86
??????????? (?????)
??? ??=5 ??=3 ????=2
???????2??=1????
?? (?????)? ??=2.5 ??=1.5 ????=1
?????B/S????????1??=2????
??????
?? (?????)? ??=10 ??=6 ????=1
??????CTA??=3
CTA= cumulative translation adjustment
• Translation gains (losses) increase (decrease) this
account balance.
• However, the gains and losses are not “realized” until
the parent company sells or shuts down the
subsidiary.
Consolidating International Financial Statements
• Both individuals and businesses must pay taxes on
income.
• The income of sole proprietorships and partnerships is
taxed as the income of the individual owners, whereas
corporate income is subject to corporate taxes.
• Both individuals and businesses can earn two types of
income -- ordinary and capital gains.
• Under current law, tax treatment of ordinary income
and capital gains change frequently due to frequently
changing tax laws.
Business Taxation
• Ordinary income is earned through the sale of a firms
goods or services and is taxed at the rates depicted in
Table 3.4 on the following slide.
Business Taxation
Ordinary Income
Example
Calculate federal income taxes due if taxable income is
$80,000.
Tax = .15 ($50,000) + .25 ($25,000) + .34 ($80,000 - $75,000)
Tax = $15,450
Business Taxation
Ordinary Income
Business Taxation
Average & Marginal Tax Rates
Example
What is the marginal and average tax rate for the previous
example?
Marginal Tax Rate = 34%
Average Tax Rate = $15,450/$80,000 = 19.31%
• A firm’s marginal tax rate represents the rate at which
additional income is taxed.
• The average tax rate is the firm’s taxes divided by
taxable income.
• Table 3.5 illustrates average tax rates at various levels
of taxable income.
Business Taxation
Business Taxation
Tax on Interest & Dividend Income
• For corporations only, 70% of all dividend income
received from an investment in the stock of another
corporation in which the firm has less than 20%
ownership is excluded from taxation.
• This exclusion is provided to avoid triple taxation for
corporations.
• Unlike dividend income, all interest income received is
fully taxed.
??municipal bond??
Business Taxation
Debt versus Equity Financing
Example
A firm with 100,000 shares outstanding needs to raise an
additional 500,000 in capital. They can do so by selling
bonds that pay 6% interest or by issuing 10,000
additional shares at $50/share. The firm pays $3.00 in
dividends for each share outstanding.
• In calculating taxes, corporations may deduct operating
expenses and interest expense but not dividends paid.
• This creates a built-in tax advantage for using debt
financing as the following example will demonstrate.
Business Taxation
Debt versus Equity Financing
Debt Equity
Financing Financing
Operating Profit (EBIT) 700,000 $ 700,000 $
Less: Interest Expense 30,000 -
Earnings Before Taxes 670,000 $ 700,000 $
Less: Taxes (40%) 268,000 280,000
Earnings After Taxes 402,000 $ 420,000 $
Shares Outstanding 100,000 110,000
Dividends Paid 300,000 $ 330,000 $
Earnings Available to Common 102,000 $ 90,000 $
Earnings Per Share (EPS) 1.02 $ 0.82 $
The Impact of Debt vs. Equity Financing
??12,000
=30,000x0.4
Business Taxation
Debt versus Equity Financing
• As the example shows, the use of debt financing can
increase cash flow and EPS, and decrease taxes paid.
•The tax deductibility of interest and other certain
expenses reduces their actual (after-tax) cost to the
profitable firm.
• It is the non-deductibility of dividends paid that results
in double taxation under the corporate form of
organization.
??????$30,000??????
$30,000x(1-0.4)=$18,000
Business Taxation
Capital Gains
• A capital gain results when a firm sells an asset such
as a stock held as an investment for more than its
initial purchase price.
• The difference between the sales price and the
purchase price is called a capital gain.
• For corporations, capital gains are added to ordinary
income and taxed like ordinary income at the firm’s
marginal tax rate.
Business Taxation
Tax Loss Carrybacks and Carryforwards
• Corporations experiencing losses can obtain tax relief by
using tax loss carrybacks/carryforwards.
• A tax loss carryback/carryforward allows corporations
experiencing operating losses to carry tax losses back (in
time) up to 3 years and forward (in time) for as many as 15
years.
• The law required that losses first be carried back, applying
them to the earliest year allowable, and progressively
moving forward until the loss has been fully recovered or
the carryforward period has passed.
See p.92
?????0.4?96??loss$500,000??carry back?93??$115,000?94??$175,000?95?
?$85,000?????????$150,000($46,000+$70,000+$34,000)???????$125,000
($500,000-$375,000)????carry forward???????97????$22,000 ($55,000*0.4 )?
98????$28,000 [ ($125,000-$55,000)*0.4]
Before?CB/CF After?CB/CF
Year Item (1) (2)
1993 Pretax earnings $115,000 $ 0
Taxes 46,000 0
1994 Pretax earnings 175,000 0
Taxes 70,000 0
1995 Pretax earnings 85,000 0
Taxes 34,000 0
1996 Pretax earnings (500,000) 0
Taxes 0 0
1997 Pretax earnings 55,000 0
Taxes 22,000 0
1998 Pretax earnings 80,000 10,000
Taxes 32,000 4,000
1999 Pretax earnings 100,000 100,000
Taxes 40,000 40,000
2000 Pretax earnings 110,000 110,000
Taxes 44,000 44,000
Depreciation
• Depreciation is the systematic charging of a portion of
the costs of fixed assets against annual revenues over
time.
• Depreciation for tax purposes is determined by using
the modified accelerated cost recovery system
(MACRS).
• On the other hand, a variety of other depreciation
methods are often used for reporting purposes.
Depreciation
• Financial managers are much more concerned with cash
flows rather than profits.
• To adjust the income statement to show cash flows from
operations, all non-cash charges should be added back to
net profit after taxes.
• By lowering taxable income, depreciation and other non-
cash expenses create a tax shield and enhance cash flow.
Depreciation & Cash Flow
Cash flow from operation=net profit after tax+non-cash charges
(??depreciation)
ex. I/S ??
Cash basis
Depreciation
• Under the basic MACRS procedures, the depreciable
value of an asset is its full cost, including outlays for
installation.
• No adjustment is required for expected salvage value.
• For tax purposes, the depreciable life of an asset is
determined by its MACRS recovery predetermined
period.
• MACRS property classes and rates are shown in
Table 3.7 and Table 3.8 on the following slides.
Depreciable Value & Depreciable Life
Depreciation
Depreciation
Depreciation
An Example
Elton Corporation acquired, for an installed cost of
$40,000, a machine having a recovery period of 5 years.
Using the applicable MACRS rates, the depreciation
expense each year is as follows:
Year Cost MACRS Rates Depreciation
1 40,000 $ 20% 8,000 $
2 40,000 $ 32% 12,800 $
3 40,000 $ 19% 7,600 $
4 40,000 $ 12% 4,800 $
5 40,000 $ 12% 4,800 $
6 40,000 $ 5% 2,000 $
Totals 100% 40,000 $
Question?
If as a business owner you could design a
depreciation schedule to look the way you wanted
it to, what would it look like?
Exactly!
As long as you have positive taxable income, you
would always prefer to expense it (100%
depreciation). Remember, a dollar saved today is
worth more than a dollar saved tomorrow!
Depreciation
Analyzing the Firm’s Cash Flows
• The statement of cash flows summarizes the firm’s
cash flow over a given period of time.
• The statement of cash flows is divided into three
sections:
– operating flows
– investment flows
– financing flows
• The nature of these flows is shown in Figure 3.2 on
the following slide.
Analyzing the Firm’s Cash Flows
Analyzing the Firm’s Cash Flows
Classifying Sources & Uses of Cash
• The statement of cash flows essentially summarizes
the sources and uses of cash during a given period.
Analyzing the Firm’s Cash Flows
Classifying
Sources &
Uses of
Cash
Analyzing the Firm’s Cash Flows
Classifying
Sources &
Uses of
Cash
The
Statement
of Cash
Flows
???
???
???
???
??
Analyzing the Firm’s Cash Flows
Interpreting the Statement of Cash Flows
• The statement of cash flows ties the balance sheet at
the beginning of the period with the balance sheet at
the end of the period after considering the
performance of the firm during the period through the
income statement.
• “Net Increase (decrease) in cash and marketable
securities should be equivalent to the difference
between the cash and marketable securities on the
balance sheet at the beginning of the year and the end
of the year.
doc_831517258.ppt
Describe the basic purpose and components of the stockholder’s report. Review the format and key components of the income statement, the balance sheet, the statement of retained earnings, the statement of cash flows, and the procedures for consolidating international financial statements
Principals of
Managerial Finance
9th Edition
Chapter 3
Financial Statements, Taxes,
Depreciation, and Cash Flow
Learning Objectives
• Describe the basic purpose and components of the
stockholder’s report.
• Review the format and key components of the income
statement, the balance sheet, the statement of
retained earnings, the statement of cash flows, and
the procedures for consolidating international financial
statements.
• Understand the effect of depreciation and other non-
cash charges on the firm’s cash flows.
Learning Objectives
• Determine the depreciable value of an asset, its
depreciable life, and the amount of depreciation
allowed each year for tax purposes using the modified
accelerated cost recovery system (MACRS).
• Analyze the firm’s cash flows and develop and
interpret the statement of cash flows.
• Discuss the fundamentals of business taxation of
ordinary income and capital gains, and he treatment of
tax losses.
• The guidelines used to prepare and maintain financial
records and reports are known as generally accepted
accounting principles (GAAP).
• GAAP is authorized by the Financial Accounting
Standards Board (FASB).
• Public corporations with more than $5 million in assets
and more than 500 stockholders are required by the
SEC to provide heir stockholders with an annual
stockholders report.
The Stockholders’ Report
• The income statement provides a financial summary
of a company’s operating results during a specified
period.
• Although they are prepared annually for reporting
purposes, they are generally computed monthly by
management and quarterly for tax purposes.
Financial Statements
The Income Statement
Financial Statements
EBIT
?????
??
• The balance sheet presents a summary of a firm’s
financial position at a given point in time.
• Assets indicate what the firm owns, equity represents
the owners’ investment, and liabilities indicate what
the firm has borrowed.
Financial Statements
The Balance Sheet
Financial Statements
=raw material+work-in-process+finished goods
+100
+400
-100
-300
+300
+100
????
Financial Statements
??????
?????or????
+200
-100
-100
+200
+100
• The statement of retained earnings reconciles the net
income earned and dividends paid during the year,
with the change in retained earnings.
Financial Statements
Statement of Retained Earnings
Financial Statements
• The statement of cash flows provides a summary of
the cash flows over the period of concern, typically the
year just ended.
• This statement not only provides insight into a
company’s investment, financing and operating
activities, but also ties together the income statement
and previous and current balance sheets.
Financial Statements
Statement of Cash Flows
Financial Statements
• FASB 52 mandated that U.S. based companies
translate their foreign-currency denominated assets
and liabilities into dollars using the current rate
(translation) method.
• Under the translation method, companies translate
foreign-currency-denominated assets and liabilities
into dollars for consolidation with the parent
company’s financial statements.
• Income statement items are usually treated similarly,
although they can also be translated at the average
exchange rate during the period (year).
Consolidating International Financial Statements
?????
• Equity accounts, on the other hand, are translated into
dollars by using the exchange rate that prevailed when
the parent’s equity investment was made (the
historical rate).
• Retained earnings are adjusted to reflect each year’s
operating profits (or losses), but does not consider any
profits or losses resulting from currency changes.
• Instead, translation gains and losses are accumulated
in an equity reserve account called the cumulative
translation adjustment.
Consolidating International Financial Statements
See an example on p.86
??????????? (?????)
??? ??=5 ??=3 ????=2
???????2??=1????
?? (?????)? ??=2.5 ??=1.5 ????=1
?????B/S????????1??=2????
??????
?? (?????)? ??=10 ??=6 ????=1
??????CTA??=3
CTA= cumulative translation adjustment
• Translation gains (losses) increase (decrease) this
account balance.
• However, the gains and losses are not “realized” until
the parent company sells or shuts down the
subsidiary.
Consolidating International Financial Statements
• Both individuals and businesses must pay taxes on
income.
• The income of sole proprietorships and partnerships is
taxed as the income of the individual owners, whereas
corporate income is subject to corporate taxes.
• Both individuals and businesses can earn two types of
income -- ordinary and capital gains.
• Under current law, tax treatment of ordinary income
and capital gains change frequently due to frequently
changing tax laws.
Business Taxation
• Ordinary income is earned through the sale of a firms
goods or services and is taxed at the rates depicted in
Table 3.4 on the following slide.
Business Taxation
Ordinary Income
Example
Calculate federal income taxes due if taxable income is
$80,000.
Tax = .15 ($50,000) + .25 ($25,000) + .34 ($80,000 - $75,000)
Tax = $15,450
Business Taxation
Ordinary Income
Business Taxation
Average & Marginal Tax Rates
Example
What is the marginal and average tax rate for the previous
example?
Marginal Tax Rate = 34%
Average Tax Rate = $15,450/$80,000 = 19.31%
• A firm’s marginal tax rate represents the rate at which
additional income is taxed.
• The average tax rate is the firm’s taxes divided by
taxable income.
• Table 3.5 illustrates average tax rates at various levels
of taxable income.
Business Taxation
Business Taxation
Tax on Interest & Dividend Income
• For corporations only, 70% of all dividend income
received from an investment in the stock of another
corporation in which the firm has less than 20%
ownership is excluded from taxation.
• This exclusion is provided to avoid triple taxation for
corporations.
• Unlike dividend income, all interest income received is
fully taxed.
??municipal bond??
Business Taxation
Debt versus Equity Financing
Example
A firm with 100,000 shares outstanding needs to raise an
additional 500,000 in capital. They can do so by selling
bonds that pay 6% interest or by issuing 10,000
additional shares at $50/share. The firm pays $3.00 in
dividends for each share outstanding.
• In calculating taxes, corporations may deduct operating
expenses and interest expense but not dividends paid.
• This creates a built-in tax advantage for using debt
financing as the following example will demonstrate.
Business Taxation
Debt versus Equity Financing
Debt Equity
Financing Financing
Operating Profit (EBIT) 700,000 $ 700,000 $
Less: Interest Expense 30,000 -
Earnings Before Taxes 670,000 $ 700,000 $
Less: Taxes (40%) 268,000 280,000
Earnings After Taxes 402,000 $ 420,000 $
Shares Outstanding 100,000 110,000
Dividends Paid 300,000 $ 330,000 $
Earnings Available to Common 102,000 $ 90,000 $
Earnings Per Share (EPS) 1.02 $ 0.82 $
The Impact of Debt vs. Equity Financing
??12,000
=30,000x0.4
Business Taxation
Debt versus Equity Financing
• As the example shows, the use of debt financing can
increase cash flow and EPS, and decrease taxes paid.
•The tax deductibility of interest and other certain
expenses reduces their actual (after-tax) cost to the
profitable firm.
• It is the non-deductibility of dividends paid that results
in double taxation under the corporate form of
organization.
??????$30,000??????
$30,000x(1-0.4)=$18,000
Business Taxation
Capital Gains
• A capital gain results when a firm sells an asset such
as a stock held as an investment for more than its
initial purchase price.
• The difference between the sales price and the
purchase price is called a capital gain.
• For corporations, capital gains are added to ordinary
income and taxed like ordinary income at the firm’s
marginal tax rate.
Business Taxation
Tax Loss Carrybacks and Carryforwards
• Corporations experiencing losses can obtain tax relief by
using tax loss carrybacks/carryforwards.
• A tax loss carryback/carryforward allows corporations
experiencing operating losses to carry tax losses back (in
time) up to 3 years and forward (in time) for as many as 15
years.
• The law required that losses first be carried back, applying
them to the earliest year allowable, and progressively
moving forward until the loss has been fully recovered or
the carryforward period has passed.
See p.92
?????0.4?96??loss$500,000??carry back?93??$115,000?94??$175,000?95?
?$85,000?????????$150,000($46,000+$70,000+$34,000)???????$125,000
($500,000-$375,000)????carry forward???????97????$22,000 ($55,000*0.4 )?
98????$28,000 [ ($125,000-$55,000)*0.4]
Before?CB/CF After?CB/CF
Year Item (1) (2)
1993 Pretax earnings $115,000 $ 0
Taxes 46,000 0
1994 Pretax earnings 175,000 0
Taxes 70,000 0
1995 Pretax earnings 85,000 0
Taxes 34,000 0
1996 Pretax earnings (500,000) 0
Taxes 0 0
1997 Pretax earnings 55,000 0
Taxes 22,000 0
1998 Pretax earnings 80,000 10,000
Taxes 32,000 4,000
1999 Pretax earnings 100,000 100,000
Taxes 40,000 40,000
2000 Pretax earnings 110,000 110,000
Taxes 44,000 44,000
Depreciation
• Depreciation is the systematic charging of a portion of
the costs of fixed assets against annual revenues over
time.
• Depreciation for tax purposes is determined by using
the modified accelerated cost recovery system
(MACRS).
• On the other hand, a variety of other depreciation
methods are often used for reporting purposes.
Depreciation
• Financial managers are much more concerned with cash
flows rather than profits.
• To adjust the income statement to show cash flows from
operations, all non-cash charges should be added back to
net profit after taxes.
• By lowering taxable income, depreciation and other non-
cash expenses create a tax shield and enhance cash flow.
Depreciation & Cash Flow
Cash flow from operation=net profit after tax+non-cash charges
(??depreciation)
ex. I/S ??
Cash basis
Depreciation
• Under the basic MACRS procedures, the depreciable
value of an asset is its full cost, including outlays for
installation.
• No adjustment is required for expected salvage value.
• For tax purposes, the depreciable life of an asset is
determined by its MACRS recovery predetermined
period.
• MACRS property classes and rates are shown in
Table 3.7 and Table 3.8 on the following slides.
Depreciable Value & Depreciable Life
Depreciation
Depreciation
Depreciation
An Example
Elton Corporation acquired, for an installed cost of
$40,000, a machine having a recovery period of 5 years.
Using the applicable MACRS rates, the depreciation
expense each year is as follows:
Year Cost MACRS Rates Depreciation
1 40,000 $ 20% 8,000 $
2 40,000 $ 32% 12,800 $
3 40,000 $ 19% 7,600 $
4 40,000 $ 12% 4,800 $
5 40,000 $ 12% 4,800 $
6 40,000 $ 5% 2,000 $
Totals 100% 40,000 $
Question?
If as a business owner you could design a
depreciation schedule to look the way you wanted
it to, what would it look like?
Exactly!
As long as you have positive taxable income, you
would always prefer to expense it (100%
depreciation). Remember, a dollar saved today is
worth more than a dollar saved tomorrow!
Depreciation
Analyzing the Firm’s Cash Flows
• The statement of cash flows summarizes the firm’s
cash flow over a given period of time.
• The statement of cash flows is divided into three
sections:
– operating flows
– investment flows
– financing flows
• The nature of these flows is shown in Figure 3.2 on
the following slide.
Analyzing the Firm’s Cash Flows
Analyzing the Firm’s Cash Flows
Classifying Sources & Uses of Cash
• The statement of cash flows essentially summarizes
the sources and uses of cash during a given period.
Analyzing the Firm’s Cash Flows
Classifying
Sources &
Uses of
Cash
Analyzing the Firm’s Cash Flows
Classifying
Sources &
Uses of
Cash
The
Statement
of Cash
Flows
???
???
???
???
??
Analyzing the Firm’s Cash Flows
Interpreting the Statement of Cash Flows
• The statement of cash flows ties the balance sheet at
the beginning of the period with the balance sheet at
the end of the period after considering the
performance of the firm during the period through the
income statement.
• “Net Increase (decrease) in cash and marketable
securities should be equivalent to the difference
between the cash and marketable securities on the
balance sheet at the beginning of the year and the end
of the year.
doc_831517258.ppt