3 Chapter Financial Statements, Cash Flows, and Taxes
Learning Objectives
1. Discuss generally accepted accounting principles (GAAP) and their importance to the economy.
2.
Explain the balance sheet identity and why a balance sheet must balance.
3. Describe how market-value balance sheets differ from book-value balance sheets. 4. Identify the basic equation for the income statement and the information it provides.
5.
Understand the calculation of cash flows from operating, investing, and financing activities required in the statement of cash flows.
6. Explain how the four major financial statements discussed in this chapter are related. 7. Identify the cash flow to a firm's investors using its financial statements. 8. Discuss the difference between average and marginal tax rates.
I.
Chapter Outline
3.1 Financial Statements and Accounting Principles A. Annual Reports
The annual report is a vehicle by which management communicates with the firm's shareholders and the general public.
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The annual report has three sections--a financial summary related to the past year's performance; information about the company, its products, and its activities; and audited financial statements, including historical financial data.
B.
Generally Accepted Accounting Principles (GAAP)
The GAAP is accounting rules and standards that companies need to adhere to when they prepare financial statements and reports.
GAAP is prepared by the Financial Accounting Standards Board (FASB) and is authorized by the SEC.
C.
Fundamental Accounting Principles
The Assumption of Arm's-Length Transaction--Two parties involved in an economic transaction arrive at a decision independently and rationally.
The Cost Principle--The value of an asset that is recorded on a company's books reflects its historical cost.
The Realization Principle--Revenue is recognized when transaction is completed, while cash may not be collected until a later time.
The Matching Principle--Expenses related to generating any revenue are matched.
The Going Concern Assumption--It is assumed that a company will continue to operate for the foreseeable future.
D.
International GAAP
The SEC is reviewing proposals for U.S. corporations to adopt IASB for financial reporting by as early as 2015.
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3.2
The Balance Sheet A. The balance sheet identifies all the assets and liabilities of a firm at a point in time.
The left-hand side of the balance sheet shows all the assets that the firm owns and uses to generate revenues.
The right-hand side represents the liabilities of the firm. In addition to the amount borrowed from suppliers and other creditors, the balance sheet also lists the capital raised from its shareholders.
While assets are listed in their order of their liquidity, the liabilities are listed in the order in which they must be paid.
B.
Shareholders of the firm's common equity are listed last.
Current Assets and Liabilities All assets that are likely to be converted to cash within a year are considered to be current assets. These include cash and marketable securities, accounts receivables, and inventory.
All liabilities that have to be paid within a year are listed as part of the current liabilities.
C.
Net Working Capital Net working capital is a measure of the liquidity of a firm, which is the ability of the firm to meet its obligations as they come due.
As expressed in Equation 3.2, net working capital is the difference between total current assets and total current liabilities.
D.
Accounting for Inventory
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Inventory, the least liquid of current assets, is reported in one of two different ways on the balance sheet.
First in, first out, or FIFO, refers to the practice of recognizing a sale as being made up of inventory that was purchased earlier and having the lowest cost.
Last in, last out, or LIFO, calls for the firm to attribute any sale made to the most recently acquired and most expensive inventory.
FIFO reporting leads to higher current asset value and higher net income. Firms may switch from one to another only under extraordinary circumstances and not frequently.
E.
Long-Term Assets
Long-term assets are the real assets that the firm acquires to produce its products and generate cash flows. These include land, buildings, plant, and equipment.
Intangible assets, such as goodwill, patents, and copyrights, are also listed here.
All long-term real assets are depreciated, while intangible assets are amortized. Depreciating assets allows a firm to lower taxable income and reduce taxes.
Firms are allowed to depreciate assets using the straight-line method or an accelerated depreciation method that is allowed by the IRS.
F.
Long-Term Liabilities
Long-term liabilities consist of the long-term debt of the company.
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They include bank loans, mortgages, and bonds that have a maturity of one year or longer.
G.
Equity
There are two sources of equity funds--common equity and preferred equity. Common equity represents the true ownership of the firm. Multiple accounts identify the various sources of equity funds--par value, additional paid-in capital, retained earnings, and treasury stock.
Par value and paid-in capital represent the outside equity capital raised by the firm by issuing shares.
Retained earnings result from the funds that the firm has reinvested in the firm from its earnings. These funds are not cash since they already have been put to work.
The treasury stock account reflects the value of the shares that the firm repurchased from investors.
The other source of equity capital is preferred stock. It has features that make it a combination of a fixed income security and an equity security. o In the event of bankruptcy, it has a higher claim that common stock but a lower claim than debt.
3.3
Market Value versus Book Value Traditionally, all assets are reported at their historical cost. A. A More Informative Balance Sheet
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The balance sheet does not reflect the current market value of the assets, only their acquired cost.
Adopting a marking to market approach--that is, reporting assets at their current market value--provides better information to management and investors.
B.
A Market-Value Balance Sheet
The difficulty of a market value balance sheet lies in estimating market values of assets.
When both the liabilities and assets of a firm are reported at their current market value, their difference represents the true market value of shareholders' equity.
3.4
The Income Statement and the Statement of Retained Earnings A. The Income Statement
The profitability of a firm for any reporting period is measured in the financial statement. The basic identity is shown in Equation 3.3.
Revenues represent the value of the products and services sold by the firm, and they include both cash and credit sales.
Expenses range from the cost of producing goods for sale and asset utilization costs such as depreciation or amortization.
B.
Net income is the difference between the firm's revenues and expenses.
A Closer Look at Some Expense Categories
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Depreciation expense reduces a firm's taxable income as well as the firm's taxes, while increasing the cash flow available to shareholders.
Firms can use one of two methods of depreciating an asset: the straight-line method and the accelerated depreciation method. Firms are allowed to use one approach for internal purposes and another for tax purposes.
Firms prefer the accelerated depreciation method for tax purposes because it allows the firm to write off larger amounts of the cost of an asset over a shorter period.
Amortization expenses are related to the writing off of the value of intangible assets like goodwill, patents, and licenses. It is also a noncash expense like depreciation.
Extraordinary items refer to income or expenses associated with events that are not expected to happen on a regular basis.
C.
Step by Step to the Bottom Line
The first bottom-line income figure that would be of interest to shareholders and creditors is earnings before interest, taxes, depreciation, and amortization (EBITDA), which is the earnings generated from operations prior to the recognition of expenses not directly connected to the production of the products.
After netting out the expenses related to depreciation and amortization, we arrive at earnings before interest and taxes (EBIT).
The next important income line is earnings before taxes (EBT) and represents the taxable income for the period.
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Finally, subtracting taxes from EBT yields net income, or net income after taxes. This amount tells us the amount available to management to pay dividends, pay off debt, or reinvest in the firm.
D.
The Statement of Retained Earnings This financial statement shows the changes in this account from one period to the next. This account will show changes whenever a firm reports a loss or profit and when a cash dividend is declared.
3.5
The Statement of Cash Flows A. Sources and Used of Cash The statement of cash flows shows the company's cash inflows and cash outflows for a period of time. o Derived by looking at the firm's net income during the period and at changes in balance sheet accounts from the beginning of the period to the end of the period. o Increases (decreases) in assets or decreases (increases) in liabilities and equity are uses (sources) of cash. B. Organization of the Statement of Cash Flows
This financial statement helps to measure the cash outflows and the cash inflows generated during any period.
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The statement is broken down into three parts to identify the cash flows resulting from operating activities, investing activities, and financing activities.
Operating activities: Cash inflows that are related to a firm's principal business activities.
Long-Term Investing activities: Cash inflows and outflows arise out of the acquisition and sale of long-term assets.
Financing Activities: When a firm issues debt or equity securities and borrows money from banks or other lenders, it produces cash inflows. If the firm pays interest or dividends on the investor's funds, or pays off debt or purchases treasury stock, the firm has cash outflows.
Cash Reconciliation: This last part the reconciles cash account from the beginning of the period to the end of the period.
The sum of the cash flows from these activities measures the net cash flows of the firm during a given period and is the bottom line of this financial statement.
3.6
Tying the Financial Statements Together The role of the balance sheet includes the following:
The balance sheet brings all the financial statements together, summarizing the financing and investment activities of the firm at a point in time.
It recognizes the changes in the company's financial position since the last reporting period that resulted from new activities or discontinued activities.
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Those changes are more descriptively measured in the income statement, the statement of cash flows, and the statement of retained earnings.
3.7
Cash Flows to Investors A. Net Income versus the Cash Flow to Investors The cash flow that a firm generates for its investors in a given period, excluding the cash inflows from the sale of securities to investors. o Cash flow to investors from operating activity equal to (CFOA): EBIT Current taxes + Noncash Expense (Equation 3.4).
o
Cash Flow Invested in Working Capital is (CFNWC): NWC current period NWC previous period (Equation 3.5).
o
Cash Flow Invested in Long-Term Assets is (CFLTA): Long-term assets
current period
Long-term assets previous period (Equation 3.6).
o Cash Flow to Investors is (CFI): CFOA CFNWC CFLTA (Equation 3.7).
3.8
Federal Income Tax A. Corporate Income Tax Rates
The federal income tax schedule for the year 2010 is shown in Exhibit 3.6. It is a progressive tax schedule with rates ranging from 15 to 39 percent. This means the higher a firm's taxable income, the higher the tax liability.
B.
Average versus Marginal Tax Rates
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The average tax rate is the total taxes paid divided by taxable income for the period.
The marginal tax rate is the tax rate that is paid on the last dollar earned or the next dollar earned.
C.
Unequal Treatment of Dividends and Interest Payments
The current tax code in the United States allows interest payments on debt issued by firms to be tax deductible.
Dividends paid on the firm's preferred stock or common stock is not deductible for tax purposes and is paid from after-tax income.
The result is a lower cost of debt financing relative to the cost of equity financing.
II.
Suggested and Alternative Approaches to the Material
This chapter focuses on the four important financial statements that every firm uses to provide information about the financial condition of the company to both management and investors. In addition, there are discussions on the generally accepted accounting principles (GAAP) and International GAAP. The chapter also overviews market value accounting. Many instructors may choose to cover this chapter in detail. This allows the students to better understand the reporting of accounting information before moving on to the analysis of financial statements in Chapter 4. This material becomes even more critical when the majority of students taking the required first course in Finance are not Finance or Accounting majors. Other instructors may choose to skim through the topics in this chapter if they feel that their students are adequately prepared to tackle the topics in the next couple of chapters. Or they
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can choose to skip this chapter altogether if their students have a strong enough accounting background. This alternative will be especially helpful if this is a second Finance course, and it will allow the instructor to cover other material.
III. Summary of Learning Objectives
1. Discuss generally accepted accounting principles (GAAP) and their importance to the economy. GAAP are a set of authoritative guidelines that define accounting practices at a particular point in time. The principles determine the rules for how a company maintains its accounting system and how it prepares financial statements. Accounting standards are important because without them, each firm could develop its own unique accounting practices, which would make it difficult for anyone to monitor the firm's true performance or compare the performance of different firms. The result would be a loss of confidence in the accounting system and the financial reports it produces. Fundamental accounting principles include that transactions are arms-length, the cost principle, the realization principle, the matching principle, and the going concern assumption.
2.
Explain the balance sheet identity and why a balance sheet must balance. A balance sheet provides a summary of a firm's financial position at a particular point in time. It identifies the productive resources (assets) that a firm uses to generate income, as well as the sources of funding from creditors (liabilities) and owners (stockholders' equity) that were used to buy the assets. The balance sheet identity is: Total assets = Total liabilities + Total stockholders' equity. Stockholders' equity represents ownership in the
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firm and is the residual claim of the owners after all other obligations to creditors, employees, and vendors have been paid. The balance sheet must always balance because the owners get what is left after all creditors have been paid--that is Total stockholders' equity = Total assets Total liabilities.
3.
Describe how market-value balance sheets differ from book-value balance sheets. Book value is the amount a firm paid for its assets at the time of purchase. The current market value of an asset is the amount that a firm would receive for the asset if it were sold on the open market (not in a forced liquidation). Most managers and investors are more concerned about what a firm's assets can earn in the future than about what the assets cost in the past. Thus, marked-to-market balance sheets are more helpful in showing a company's true financial condition than balance sheets based on historical costs. Of course, the problem with marked-to-market balance sheets is that it is difficult to estimate market values for some assets and liabilities.
4.
Identify the basic equation for the income statement and the information it provides. An income statement presents a firm's profit or loss for a period of time, usually a month, quarter, or year. The income statement identifies the major sources of revenues generated by the firm and the corresponding expenses needed to generate those revenues. The equation for the income statement is Net income = Revenues Expenses. If revenues exceed expenses, the firm generates a net profit for the period. If expenses exceed
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revenues, the firm generates a net loss. Net profit or income is the most comprehensive accounting measure of a firm's performance.
5.
Understand the calculation of cash flows from operating, investing, and financing activities required in the statement of cash flows. Cash flows from operating activities in the statement of cash flows are the net cash flows that are related to a firm's principal business activities. The most important items are the firm's net income, depreciation and amortization expense, and working capital accounts (other than cash and short-term debt obligations, which are classified elsewhere). Cash flows from long-term investing activities relate to the buying and selling of long-term assets. Cash flows from financing occur when cash is obtained from or repaid to creditors or owners (stockholders). Typical financing activities involve cash received from the issuance of common or preferred stock, as well as cash from bank loans, notes payable, and long-term debt. Cash payments of dividends to stockholders and cash purchases of treasury stock reduce a company's cash position.
6.
Explain how the four major financial statements discussed in this chapter are related. The four financial statements discussed in the chapter are the balance sheet, the income statement, the statement of cash flows, and the statement of retained earnings. The key financial statement that ties the other three statements together is the statement of cash flows, which summarizes changes in the balance sheet from the beginning of the year to
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the end. These changes reflect the information in the income statement and the statement of retained earnings.
7.
Identify the cash flow to a firm's investors using its financial statements. Cash flow to investors is the cash flow that a firm generates in a given period (cash receipts less cash payments and investments), excluding cash inflows from new equity sales or long-term debt issues. Cash flow to investors is the cash flow in a given period that is used to meet the firm's obligations to its debt holders and that is distributed to its equity investors, which in turn defines the value of their investments in the firm over time. The cash flow to investors is calculated as the cash flow to investors from operating activity, minus the cash flow invested in net working capital, minus the cash flow invested in long-term assets.
8.
Discuss the difference between average and marginal tax rates. The average tax rate is computed by dividing the total taxes by taxable income. It takes into account the taxes paid at all levels of income and will normally be lower than the marginal tax rate, which is the rate that is paid on the last dollar of income earned. However, for very high income earners, these two rates can be equal. When companies are making financial investment decisions, they use the marginal tax rate because new projects are expected to generate additional cash flows, which will be taxed at the firm's marginal tax rate.
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IV. Summary of Key Equations
Equation 3.1 3.2 3.3
Description Balance sheet
Formula Total assets = Total liabilities + Total stockholders' equity
3.4
identity Net working capital Net working capital = Total current assets Total current liabilities Income Statement Net income = Revenues Expenses identity Cash flow from CFOA = EBIT Current Taxes + Noncash expenses operating activity Cash flow invested in net working capital Cash flow invested CFNWC = NWC current period NWC previous period
3.5
3.6 in long-term assets Cash flow to 3.7 investors
CFLTA = Long-term assets current period Long-term assets previous period
CFI = CFOA CFNWC CFLTA
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