Chapter 7

By Sally Washington,2014-06-27 23:04
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Chapter 7 ...

    Chapter 2

    Financial Statements, Cash Flows, and Taxes

    Financial statements provide the foundation data for many topics in Finance.

A. Basics

    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 -

     sales allowances)

    - 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)


     - Cs

     - As (Ds)

     = EBIT

     - I

     - T

     = NI

     = 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

    balance sheet.

     Book value

     = (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

    pay owners.

    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

    against sales

     tax-deductible expense

     non-cash expense

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

    the period

     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

    Selling price

    =$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:

     10?20.25UCC(bookvalue)?$100,000?(1?)?(1?0.25)?$8,760 BegYr102


     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

    : contains

    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

    annual report

    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


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