Financial Statements, Cash Flows, and Taxes
Financial statements provide the foundation data for many topics in Finance.
a. Canadian Institute of Chartered Accountants (CICA)
: sets and develops accounting standards
Ensure companies provide information that meets the needs of users of financial
b. Generally accepted accounting principles (GAAP)
: the guidelines used to prepare and maintain financial records, reports and
B. Income Statement
: provides a financial summary of the firm’s operating results for a specified period
Normally cover one fiscal year – 12 months
Income statement concept:
Revenues (Net sales=sales – sales discount – sales returns -
- Costs (costs of goods sold + other costs such as:
administrative costs, utility, rent, …….)
- Depreciation &
Amortization (equipments, machines, trucks, building,
= Earnings before interest and taxes (EBIT, or operating earnings)
- Interest (loans, borrowings, bonds..)
- Taxes (provincial / state and federal) = Net income (after taxes)
= Dividends (cash or stock: represent current income)
+ Retained earnings (for future investments: represent future growth or
capital appreciation/gain) ? the number of common shares outstanding
= Earnings per share (EPS)
- As (Ds)
= Div. + RE
C. Balance Sheet
: a summary statement of the firm’s financial position at a given point in time
Assets (A) = Liabilities (L) + Stockholders’ equity (SE)
Assets = Liabilities + Stockholders’ equity
how the money was spent = sources of funds: where the money came from
Assets: Liabilities and Shareholders’ equity:
Current Assets (short-term) Current Liabilities (short-term)
Cash Accounts payable
Marketable securities Notes payable and line of credit
Accounts receivable Accrued expenses
prepaid expenses Long-term Liabilities
Capital Assets (long-term)
Building, furniture Shareholders’ Equity
Less accumulated amortization Preferred stock
Plant, equipment, machinery Capital stock
Less accumulated amortization Retained earnings
Vehicles and others
Less accumulated amortization
Total Assets Total liabilities and shareholders’ equity
? May see other intangible assets on a balance sheet such as goodwill, trademarks,
patents, franchise rights
Goodwill is created only when a business is purchased and the amount paid for the
business is greater than the value of the assets acquired. The premium paid is an
asset termed goodwill.
Book value (or net worth) is the total value of common equity as of the date of the
= (capital stock + retained earnings) / the number of common shares outstanding
D. Statement of Cash Flows
: provides a summary of inflows and outflows of cash over the period of time
: provides a summary of the firm’s operating, investing, and financing cash flows and
reconciles them with changes in its cash and marketable securities during the
period of concern
a. Operating activities:
Cash flows relate to the firm’s production cycle – from the purchase of raw
materials to the finished products. Any expenses incurred directly related to this
process are considered operating flows.
b. Investing activities:
Cash flows result from the purchase and sales of fixed assets and business interests.
c. Financing activities:
Cash flows result from borrowing and repayment of debt obligations and from
equity transactions such as sale or purchase of shares and dividend payments.
1. Increase in any liability.
2. Decrease in any asset.
3. Net income after taxes.
4. Amortization and other non-cash expenses.
5. Sale of shares.
1. Increase in any asset.
2. Decrease in any liability.
3. Net loss.
4. Dividends paid.
5. Repurchase or retirement of shares.
Interpretation of cash flow
CF from CF from CF from General explanation
operating investing financing
1 + + +
Company is using cash generated from
operations, sale of assets, and financing to
build up pile of cash – very liquid firm –
possibly looking for acquisition.
Company is using cash flows generated from 2 + - - operations to buy fixed assets and to pay
down debt or pay owners.
Company is using cash from operations and 3 + + - from sale of fixed assets to pay down debt or
Company is using cash from operations and 4 + - + from borrowing (or from owners’ investment)
to expand – good potential.
Company’s operating cash flow problems are 5 - + + 3 covered by sale of fixed assets, by borrowing,
or by stockholder contributions.
Company is growing rapidly, but has
shortfalls in cash flows from operations and
from purchase of fixed assets financed by
long-term debt or new investment.
Company is financing operating cash flow 7 - + - 6 - - + shortages and payments to creditors and/or
stockholders via sale of fixed assets.
Company is using cash reserves to finance 8 - - - operation shortfall and pay long-term
creditors and/or investors.
Source: Accounting: Concepts and Applications, Albrecht, Stice, Stice, and Skousen, South-Western, 2002.
d. Free cash flow
: the cash available to make payments to the creditors and investors that supplied
capital to the company
FCFO = free cash flow from operations
= EBIT × (1-T) + amortization
FCF = FCFO – capital expenditures – changes in non-cash working capital
E. Statement of Retained Earnings
: provides details of changes in owners’ equity and retained earnings from the
beginning to the end of the fiscal year
Retained earning balance (start of year)
Plus: Net income after taxes
Less: Cash dividends paid (common and preferred)
Retained earning balance (end of year)
F. Corporate Taxation
a. Types of business income
1. Active business income: derived from normal business activities of a corporation
the difference between sales and expenses
2. Passive income: income from a specified investment business or from a personal
services business that is taxed at higher corporate tax rates
3. Intercorporate dividends: received by a corporation from investments in preferred
and common shares of other corporations
If from a taxable Canadian corp., the full amount of the dividend is not taxable.
b. Capital gains and losses
: generated from selling a capital asset for more/less than its initial purchase price
Only 50% of capital gain is taxable.
Capital losses cannot be used to reduce a firm’s operating income and are netted
against capital gains to determine the net capital gains, and 50% of this amount is
c. Tax-deductible expenses
Tax-deductibility of expenses reduces taxes.
See example on p.67
1. Interest is a tax-deductible, whereas dividends paid by the firm are not.
2. Amortization: the systematic expensing of a portion of the cost of a fixes asset
d. Tax loss carry-forward and carry-back
Companies can carry their non-capital losses back up to 3 years to reduce taxable
income in those years or forward for 20 years.
See example on p.69
Capital losses can be carried back for 3 years or forward indefinitely until fully
G. Capital cost allowance (CCA)
: the tax version of amortization
a. CCA calculaiton
CCA is not claimed on assets, but rather on asset classes.
All assets in the same class are considered in total for CCA calculation purpose.
See Table 2.6, p.72 for CCA rates
UCC: undepreciated capital cost the base for CCA calculation
See example on p.73
Ex: Tiger Beer has just acquired a new delivery truck costing $100,000. This is a class 10 asset with
a CCA rate of 30%. The CCA and UCC for the first 4 years are:
Year UCC-Beginning of year CCA for the year UCC – End of year*
1 $100,000 $15,000** $85,000
2 $85,000 $25,500 $59,500
3 $59,500 $17,850 $41,650
4 $41,650 $12,495 $29,155 *: UCC is the asset’s book value. st**: For the 1 year, only one half of allowable CCA can be claimed – half-year rule.
b. Benefit of claiming CCA
Non-cash expense: the deduction does not involve an actual outlay of cash during
CCA reduces net income and taxes but increases cash flow.
CCA creates tax-shield, tax savings associated with being able to claim non-cash
? See example on p.64
c. Recapture and terminal loss
Example: The original purchase price of the asset = $100
After a few years of amortizing the asset, UCC=$40
a. At the end of the project, if the residual selling price is $120, then :
$120 -100 = 20 Capital gain $20: only 50% ($10) will be taxable.
$40 – 100 = -60 Recapture $60: 100% taxable income
b. At the end of the project, if the residual selling price is $50, then :
$40 – 50 = -10 Recapture $10: 100% taxable income
c. At the end of the project, if the residual selling price is $25, then :
$40 – 25 = 15 Terminal loss $15: 100% tax deductible
=$120 Capital gain =$20
Original Terminal price=$100 Recapture loss =$15
d. UCC at the beginning of year n
N?2d UCC(bookvalue)?UCC?(1?)?(1?d) BegYrN2
Where d = the CCA rate for the asset
Ex: 10 years ago, E&B purchased a $100,000 asset that had a CCA rate of 25%. The
asset’s useful life is 10 years. At the beginning of year 10, the UCC of the asset is:
Assume that the asset could be sold for scrap for $12,000, then:
8,760 – 12,000 = - $3,240 recapture (100% taxable)
If the machine was sold for $2,000, then:
8,760 – 2,000 = $6,760 terminal loss
e. Investment tax credit (ITC)
: an incentive for businesses in various regions of the country to purchase certain types
of fixed assets or undertake certain types of research or development activities
The dollar amount of ITC can be deducted from federal taxes payable.
ITC = the amount of qualifying expenditure x ITC rate
The ITC can be carried back 3 years or forward 20 years if it is not used in the first
year of acquisition.
The real UCC for the asset will be the original UCC minus the ITC. (See p.78 for
H. Corporate tax rates
Canadian-controlled private corporation (CCPC): a small, private business
majority-owned by Canadian residents
CCPC will be subject to lower taxes on its active business income (ABI).
If a company is engaged in manufacturing and process, then it will pay lower
provincial taxes in some provinces.
A general company (non-manufacturer/processor) will be paying higher tax rates.
See Table 2.7 on p.80 for 2008 corporate tax rate schedule.
I. Annual report
a. Letter to shareholders: provides direct communication from senior
management to the firm’s common shareholders
b. Management’s discussion and analysis: a supplemental report that allows the
reader to look at the company through the eyes of management by providing a
current and historical analysis of the business of the company
c. Financial statements: 4 key statements
d. Management’s report: outlines management’s responsibility for preparing the
e. Auditors’ report: describes how the auditor completed the audit of the firm’s
financial records which must be “free of material misstatement” and fairly
present the financial position of the company
f. Notes to financial statements: important source of information on the
accounting policies, procedures, calculations, and transactions