Chapter Two – Financial Background:
A Review of Accounting, Financial
Statements and Taxes
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ACCOUNTING SYSTEMS
Keep financial records and produce statements
FINANCIAL STATEMENTS
Income Statement
Balance Sheet
Statement of Cash Flows
Accounting Results Can Be
Counterintuitive
Income isn't cash in hand
E.g.: Receivables
Depreciation
TM 2-1
Slide 1 of 2
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ACCOUNTING BASICS
The Double Entry System
Two sides to every entry
Where the money came from and what it's used for
"Balanced Books"
Stocks and Flows
Flows over a period: Income and Cash Statements
Stocks at a point in time: Balance Sheet
Accounting Periods
Accumulate transactions
Closing the books
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TMa2-1
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INCOME STATEMENT
Sales
$1,000
Cost of Goods Sold
600
Gross Margin
$400
Expenses
230
Earnings Before
Interest & Taxes
$170
Interest Expense
20
Earnings Before Tax $150
Tax
50
Net Income
$100
Table 2-1 A Conventional Income Statement Format
TM 2-2
Slide 1 of 3
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Sales - Revenue
Proceeds from sale of product or service (only)
COGS
Spending on things closely related to production
Material, labor, production overhead
Gross Margin
Profitability of production operations
Often expressed as a percent of sales
Expenses
Other spending - Marketing, finance, human resources
TM 2-2
Slide 2 of 3
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EBIT
Earnings before interest and taxes
The result of physical operations before financing costs
INTEREST
On borrowed capital
EBT
Earnings before taxes
Tax
On EBT Actual tax may be different
Tax vs. financial books
Net Income
The bottom line – dividends not subtracted
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BALANCE SHEET
ASSETS
Cash
Accounts
Receivable
Inventory
CURRENT
ASSETS
Fixed Assets
Gross
Accum Depr
Net
$1,000
3,000
2,000
$6,000
$4,000
(1,000)
$3,000
TOTAL ASSETS
LIABILITIES & EQUITY
Accounts
Payable
Accruals
CURRENT
LIABILITIES
Long Term Debt
Equity
$5,000
2,000
TOTAL CAPITAL
$7,000
$1,500
500
$2,000
TOTAL LIABILITIES
$9,000 AND EQUITY
$9,000
ASSETS = LIABILITIES + EQUITY
Arrangement in order of decreasing liquidity
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ASSETS
Cash
Checking accounts + Currency
Accounts Receivable
Due from sales on credit
Offset-Allowance for doubtful accounts(bad debt reserve)
Writing off of uncollectibles
Overstatement of receivables
Inventory
Raw Material, WIP, Finished Goods
Offset - Inventory reserve
Writing off bad inventory
Overstatement of inventory
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Current Assets
Become cash within a year
Generally Cash, A/R and Inventory
Fixed Assets
Long lived - depreciated
Stated Net of Accumulated Depreciation
If sold - cost is NBV
TM 2-4
Slide 3 of 4
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Year
Income Statement
Balance Sheet
1
Deprec Exp $2,500
Gross
$10,000
Accum Depr (2,500)
Net
$7,500
2
Deprec Exp $2,500
Gross
$10,000
Accum Depr (5,000)
Net
$5,000
3
Deprec Exp $2,500
Gross
$10,000
Accum Depr (7,500)
Net
$2,500
4
Deprec Exp $2,500
Gross
$10,000
Accum Depr (10,000)
Net
-0-
Table 2-3 Fixed Asset Depreciation
TM 2-4
Slide 4 of 4
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LIABILITIES
Accounts Payable
Due from purchases on credit
Terms of sale
Stretching payables
Understatements
TM 2-5
Slide 1 of 3
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Accruals
Recognizes incomplete transactions
An example:
Thurs Fri Sat Sun Mon Tues Wed Thurs Fri Sat
Payday
Payday
End of Month
Close
First Month
Second Month
Figure 2-1 A Payroll Accrual
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Current Liabilities
Due within a year
Working Capital
Current Assets - Current Liabilities
Supports routine operations
TM 2-5
Slide 3 of 3
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CAPITAL
LONG TERM DEBT
Bonds and Loans
Debt generates interest expense - Increases
risk of failure
Leverage
Amplifies return on investment - both ways
TM 2-6
Slide 1 of 3
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LEVERAGE ILLUSTRATION
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EQUITY
Direct Investment by owners paying for stock
par value and paid in excess accounts
Retained Earnings
Example: 20,000 shares of $2 par sold for $8
Firm Earns $70,000
Pays dividends of $15,000
Common Stock ($2 x 20,000)
$ 40,000
Paid in Excess ($6 x 20,000)
120,000
Retained Earnings ($70,000 - $15,000) 55,000
Total Equity
$215,000
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The Relationship Between
Net Income and Retained
Earnings
Beginning Equity + Net Income Dividends + Stock = Ending Equity
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TAXES
Tax Bases and Taxing Authorities
Income - Federal, State, a few cities
Wealth - Real estate taxes - Cities
and counties
Consumption - Sales and excise
taxes - all
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The Total Effective Income
Tax Rate
State tax is deductible from federal tax
Taxable Income for State Tax
State tax @ 10%
Taxable Income for Federal Tax
Federal Tax @ 30%
Net After Tax
Total Tax
$ 100
10
$ 90
27
$ 63
$ 37
In general: TETR = Tf + Ts(1 - Tf)
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Progressive Tax Systems
The U.S. federal tax system is progressive
in that the tax rate increases with income.
In a traditional progressive system a high
income taxpayer retains the benefit of low
rates on early income
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Tax Schedules (Tables) and Tax
Brackets
Hypothetical Example:
Bracket
Tax Rate
0 - $5,000
10%
$5,000 - $15,000
15%
over $15,000
25%
Brackets are ranges of income through which the tax
rate is constant.
©
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Marginal and Average Tax Rates
Marginal tax rate - the rate paid on the
last/next dollar of income
Average tax rate - the percent of total
income paid in taxes
The marginal rate is relevant for investment
decisions because investments are generally
made after providing for basic needs
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Tax Calculations: Progressive System
Calculate the tax on an income of
$18,000.
$5,000 × .10 = $ 500
$10,000 × .15 = $1,500
$3,000 × .25 = $ 750
$2,750
Average Rate = $2,750 / $18,000 = 15.3%
Marginal Rate = 25%
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PERSONAL TAX SCHEDULES (2015)
Taxpaying unit is a household, usually a family
Married Couples
Single Individuals
Filing Jointly
Income
Rate
Income
Rate
0 - $9,225
10%
0 - $18,450
10%
$9,225 - $37,450 15%
$18,450 - $74,900
15%
$37,450 - $90,750 25%
$74,900 - $151,200
25%
$90,750 - $189,300 28%
$151,200 - $230,450
28%
$189,300 - $411,500 33%
$230,450 - $411,500
33%
$411,500 - $413,200 35%
$411,500 - $464,850
35%
over $413,200
39.6% Over $464,850
39.6%
Table 2-4
Personal Tax Schedules
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Calculate tax on income of $85,000. Married
filing Jointly
$18,450
× .10
= $ 1,845
($74,900 - $18,450) × .15 = $ 8,467.50
($56,450)
($85,000-$74,900) × .25
($10,100)
= $ 2,525
$12,837.50
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CAPITAL GAINS ( LOSSES) AND DIVIDENDS
Income is either ordinary or capital gain/(loss)
Historically, capital gains taxed at lower rates
as an incentive to investment
Rate is currently capped according to household income
Low 0%
Middle 15%
High 20%
A maximum of $3,000 in capital losses can offset
ordinary income in a year.
Remainder can be carried forward.
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Exempt Income
Exempt from taxation:
Interest on municipal bonds
Exclude from calculations
Taxable Income
Income excluding exempt less:
Exemption of $4,000 (in 2015) per person
Itemized Deductions of
* mortgage interest on primary home
* local taxes (income and property)
* charitable contributions
* OR a Standard Deduction
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CALCULATING PERSONAL TAXES
Example 2-4:
The Harris family had the following
income in 2015:
Salaries:
Joe
$75,000
Sue
77,000
Interest on savings acct 2,000
Interest on IBM bonds
800
Interest on Boston Bonds 1,200
Dividends - Gen Motors
600
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The Harris Family’s Taxes
uring 2015 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 $2,800 in real estate
taxes. State income tax of $6,000 was withheld
from their paychecks during the year. They
contributed $1,200 to their church. They have two
children living at home. The exemption rate is
$4,000 per person. What is their taxable income
and their tax liability? Further, what are their
marginal and average tax rates?
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The Harris Family’s Taxes
During 2015 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 $2,800 in real estate
taxes. State income tax of $6,000 was withheld
from their paychecks during the year. They
contributed $1,200 to their church. They have two
children living at home. The exemption rate is
$4,000 per person. What is their taxable income
and their tax liability? Further, what are their
marginal and average tax rates?
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Solution:
Ordinary income:
Salaries
Interest
Deductions:
$152,000
Mortgage interest $12,000
2,800
Taxes
8,800
$154,800
Charity
1,200
Total deductions
$22,000
Net capital gain or loss:
Loss on property ($3,000)
Exemptions:
Gain on stock
2,000
$4,000 x 4 =
$16,000
Net capital loss
($1,000)
Taxable Income $115,800 (excl divs)
Total Income
$153,800
Use the married filing jointly schedule as follows:
10% of the entire first bracket
$18,450 x .10 =
$1,845
15% of the amount in the second bracket ($74,900 - $18,450) x .15=8,467.50
25% of the amount in the third bracket ($115,800 - $74,900) x .25 = 10,225
Tax Liability
Tax on dividends $600 x .15 =
Total tax liability
$20,537.50
90
$20,627.50
Average tax rate: $20,627.50/$116,700 = 17.67%
Marginal tax rate = bracket rate = 25%
(15% if dividends or capital gains)
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TAX RATES AND INVESTMENT
DECISIONS
Comparing corporate (interest taxable) and
municipal (interest tax exempt) bonds
Must state rates on same basis
Multiply the corporate rate by one minus the
investor's marginal tax rate
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Example 2-2
The Harris family (25% bracket) has a choice between an AT&T
bond paying 11% and a Boston bond paying 9%.
Solution:
AT&T after tax = 11% x (1 - .25) = 8.25% < Boston = 9%
Therefore prefer the Boston bond if risks are similar.
If marginal tax rate is 15%
11% x (1 - .15) = 9.35%
then prefer AT&T
High bracket taxpayers tend to be more interested in tax exempt
bonds than those with lower incomes.
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CORPORATE TAXES
Income is the business's revenue.
Deductions are costs and expenses.
Personal exemptions don't exist
Taxable income is Earnings Before Tax
(EBT)
Income per financial books vs. tax
books
TM 2-12
Slide 1 of 3
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Income
0 - $50,000
$50,000 - $75,000
$75,000 - $100,000
$100,000 - $335,000
$335,000 - $10,000,000
$10,000,000 - $15,000,000
$15,000,000 - $18,333,333
over $18,333,333
Table 2-5
Rate
15%
25%
34%
39%
34%
35%
38%
35%
Corporate Income Tax Schedule
Notice the up and down rates. Is the system
progressive?
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Goals of the system:
1. Progressive: income under $10M taxed at 34%
income over $10M taxed at 35%.
2. Lower rates on incomes up to $75,000.
3. Higher income taxpayers pay the targeted rates
on their whole incomes.
Surtaxes of 5% and 3% take away the benefit of low
early rates as income increases
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Corporate Tax Examples
Example 2-3
Tax for a corporation making EBT of $280,000.
Solution: 50,000 x .15
$25,000 x .25
$25,000 x .34
$180,000 x .39
=
=
=
=
$ 7,500
6,250
8,500
70,200
$92,450
©
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Corporate Tax Examples
Example 2-4
Tax for a corporation making EBT of
$500,000.
Solution: Between $335,000 and
$10 million, the overall tax rate is 34%.
$500,000 x .34 = $170,000
TM 2-13
Slide 2 of 3
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Corporate Tax Examples
Example 2-5
Tax for a corporation making EBT of $16
million.
Solution: The system recovers those benefits
to an overall 34% rate up to $10 million.
$10,000,000 x .34 = $3,400,000
$5,000,000 x .35 = 1,750,000
$1,000,000 x .38 =
380,000
$5,530,000
Over $18,333,333, calculate a flat 35%
TM 2-13
Slide 3 of 3
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TAXES AND FINANCING
The U.S. tax system favors debt financing because interest
is tax deductible and dividends are not.
EBIT
Interest
EBT
Tax @ 30%
EAT
Dividends
Net RE add
DEBT
$120
20
$100
30
$ 70
$70
EQUITY
$120
$120
36
$ 84
20
$ 64
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DIVIDENDS PAID TO CORPORATIONS
Tiered ownership can result in multiple taxation
Corporation B
Corporate tax on B
Dividend: B to A
Corporation A
Corporate tax on A
Dividend: A to shareholders
Shareholders
Personal Tax
Avoided by exempting dividends from one corporation to another
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DIVIDENDS PAID TO
CORPORATIONS
Ownership
<20%
20% - 80%
>80%
Exemption
70%
80%
100%
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TAX LOSS CARRY BACK AND CARRY FORWARD
YEAR
1
EBT
$100
Tax (30%)
30
EAT
$ 70
Adjusted
EBT
Tax
EAT
Figure 2-3
2
3
$100 ($250)
30
$ 70 ($250)
($100)
($100)
$0
0
$0
$0
0
$0
4
$100
30
$ 70
Total
$50
90
($40)
($50)
$0
0
$0
$ 50
15
$ 35
$50
15
$35
Tax Loss Carry Forward and Carry Back
Over the four year period paying $90 tax on earnings of $50 impossible.
Losses can be carried back two years and carried forward twenty
years.
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