CHAPTER 2



CHAPTER 3

ACCOUNTING AND FINANCE

TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS

3.1 THE BALANCE SHEET

A. The balance sheet presents the accounting value of assets and the source of money used to purchase those assets at a particular point in time.

B. Assets are usually listed in descending order of liquidity, or the ability to convert to cash.

1. Cash and marketable securities, accounts receivable, and inventories are current assets, each of which expect to cycle through cash over the next year.

2. Long-term assets, both tangible or fixed assets like plant and equipment and intangible assets such as patents and trademarks, will not be converted to cash but are expected to generate cash over future accounting cycles.

C. While the assets depict what is owned, liabilities and equity represent what is owed or who provided the funding for the assets.

1. Current liabilities, such as accounts payable, represent obligations requiring cash payment within the next year.

2. Current assets minus current liabilities are net working capital, or the extent to which current assets are financed with long-term sources of financing.

3. Long-term liabilities are debt obligations due beyond one year.

4. The difference between the accounting value of the assets and the liabilities is the shareholders’ equity, representing the original capital contribution plus the earnings retained in the business. See Figure 3.1 for a mental picture of the balance sheet.

THE MAIN BALANCE SHEET ITEMS

|Current Assets | |Current liabilities |

|Cash & securities | |Payables |

|Receivables | |Short-term debt |

|Inventories |= | |

|+ | |+ |

|Long-term Assets | |Long-term liabilities |

|Tangible assets | |+ |

|Intangible assets | |Shareholder’s Equity |

Book Values and Market Values

A. Generally Accepted Accounting Principles (GAAP) provide guidelines for preparing financial statements.

B. According to GAAP, assets and liabilities are usually “booked” (recorded) at their historical or original cost value.

C. The book value of a business represents the accounting value or the balance sheet value. The book value of net worth or equity is the book value of assets less liabilities, or the historical contributions of owners including original cash contributions (sale of stock) plus reinvested earnings (retained earnings.)

D. While book values are based on original cost, market value is based on value in use or economic value: the ability to generate future cash flows.

E. Shareholders and managers are concerned about the market value of their stock, so their focus is on a market value driven balance sheet.

F. The market value of assets minus the market value of liabilities is the market value of shareholders’ equity. See the Jupiter Motors Example 3.1.

G. Book values are based upon GAAP and market values of assets and liabilities, and thus net worth, are driven by economic value factors studied in later chapters. Seldom are they the same.

3.2 THE INCOME STATEMENT

A. The income statement is a financial statement listing the revenues, expenses, and net income of the firm over a period of time.

B. The income statement indicates where operating profit (EBIT) came from (revenues - operating costs - depreciation) and where operating income was distributed (interest to creditors, taxes to governments, and profits to shareholders).

Profits versus Cash Flow

A. Shareholders and managers are concerned about maximizing shareholder value, and therefore are oriented toward estimating and generating cash flows.

B. Profits from an income statement and cash flow usually differ because cash flow and profits are measured differently. Cash flow equals the actual dollars generated by the company minus the cash paid out. By contrast, when income or profits are measured, the accountants attempt to smooth spending over time, to correspond with the use of assets and the generation of revenues.

C. Instead of deducting the cost of a machine in the year it is purchased, the accountant spreads the cost over time through an annual charge called depreciation. Depreciation is an example of the smoothing done to match the cost of an asset with its use. By contrast, cash flow is reduced by the full cost of the assets when they are purchased.

D. Noncash expenses, such as depreciation and amortization, are allocated to a specific period to measure accounting profit. These noncash expenses cause profit to be less than actual operating cash flow. Thus noncash expenses (noncash revenues) must be added back to (subtracted from) profit to estimate cash flow in a period.

E. Another reason why profits and cash flow differ is explained by comparing cash accounting versus accrual accounting. Accrual accounting emphasizes profit measurement in a period: the revenue earned in the period; the expenses incurred in the period. However, the expenses are matched to the revenues: the accountant gathers together all of the expenses associated with the goods and services sold, regardless of when the actual costs were incurred. Cash flow is oriented to cash collected versus disbursed in a period. Adjusting entries, accruals, receivable, prepaid expenses, and payable liabilities cause accounting profits measured in a period to differ from cash flow in the same period.

F. Inventories are another reason for difference between cash flow and profit. Inventories produced or purchased typically incur an outlay of cash, but are not be expensed (through cost of goods sold) until sold. Thus, increases in inventories are paid from cash but do not affect profits until the inventory is sold.

3.3 THE STATEMENT OF CASH FLOWS

A. The statement of cash flow is a financial statement that shows the firm’s cash receipts and cash payments over a period of time.

B. The statement of cash flows explains why the cash in the company's bank account changed over the period. The increase (or decrease) in cash shown at the bottom of the statement of cash flow equals the increase (or decrease) in cash calculated using the balance sheet cash accounts.

C. The statement of cash flow is divided into three sections.

1. The cash flow provided by operating activities for a period is the sum of net income plus (minus) noncash expenses (noncash revenue) plus (minus) the net sources (uses) of cash from changes in various working capital accounts. Decreases (increases) in current asset (current liability) accounts are sources of cash. Increases (decreases) in current asset (current liability) accounts are applications or uses of cash during a period.

2. The cash flow from (used in) investments represents added net (purchase less sale) long-term (capitalized) asset investment in the period.

3. The financing cash flows are listed last and include the net change in debt outstanding, cash dividends paid, and the sale or repurchase of common stock.

4. Since every income statement ledger item and the changes in balance sheet ledger items in the period, except the change in the cash/marketable securities account, has been listed in the statement of cash flows, the balancing sum of net cash flows must equal the net change in the cash/marketable securities account in the period.

D. The information in the cash flow statement can be rearranged to calculate the cash flow from assets:

Cash flow from assets

=cash flow provided by operating activities + cash flow from (used in) investments

E. The basic equation of the statement of cash flows is:

Increase (decrease) in cash in the bank

= cash flow from assets + cash flow from (used in) financing activities

3.4 CASH FLOW FROM ASSETS, FINANCING FLOW, AND FREE CASH FLOW

A. Rearranging the basic equation of the statement of cash flows gives the fundamental cash flow identity:

Cash flow from assets = cash flow used in (from) financing activities + increase (decrease) in cash in the bank.

B. Cash flow from assets is some times called free cash flow.

C. The sum of cash flow used in (from) financing activities and the increase (decrease) in cash in the bank is called the financing flow of the firm. The fundamental cash flow identity dictates the firm's cash flow from assets must equal its financing flow. The financing flow equals the sum of the cash flow to the firm's debtholders, to its shareholders and any increase in the cash in the bank.

D. In the statement of cash flow, prepared according to GAAP, interest paid to debtholders is classified as an operating expense and not as a financing flow. To accurately measure the cash flow to debtholders, interest expense must be reclassified as a financing flow. This is accomplished by adding the interest expense back to the cash flow from assets and adding it to the financing flows. With this adjustment, the financing flow is a more complete measure of the cash paid out to the firm's financiers.

E. When interest is reclassified as a financing flow, use the following equations:

Cash flow from assets (adjusted) = cash flow from assets + interest

Financing flow (adjusted) = cash flow to debtholders + cash flow to shareholders

+ increase (decrease) in cash in the bank

Cash flow to debtholders = interest + net debt repayment (net debt issuance)

Cash flow to shareholders = dividends + net equity repayment (net equity issuance)

F. Positive cash flow from assets (or positive free cash flow) means that the company generated more cash from its operations than it spent on its investments. Where does the surplus cash go? Either it is distributed to debtholders and shareholders or shows up in the firm’s bank account. Negative cash flow from assets means that the firm used more cash in its investments than it generated from its operations. This cash shortfall is met by either raising net new financing from bondholders and shareholders or by drawing down surplus cash reserves of the company.

G. Managers must understand the cash flow from assets and financing flow of their company. Financing decisions and dividend payouts affect the availability of cash to pay for investments. Investors too care about the firm's cash flows. Will the company have cash to pay dividends and repay borrowed funds? Cash flow from assets is at the heart of valuation. The value of the company depends on the cash flow from assets the business will generate.

3.5 ACCOUNTING PRACTICE AND ACCOUNTING MALPRACTICE

A. While accounting is concerned with a presentation of earnings and book values according to GAAP, financial analysts, managers, and shareholders, current and prospective, are also interested in balance sheet and income statement adjustments that allow them to measure market values and cash flows.

B. Items such as valuable intangible assets, not normally listed on the balance sheet, conditional liabilities as pension commitments and stock options, are real variables affecting future cash flows and are a part of the value assessment process. There is a decided trend in GAAP toward accounting for market values and measuring cash flows.

C. At this time there is considerable leeway in GAAP in such areas as estimating expected credit losses (allowance or reserve for bad debts), and revenue recognition.

D. The work of the International Accounting Standards Committee toward standardizing accounting conventions worldwide will encourage the globalization of financial markets. Since the text went to print, Canada's Accounting Standards Board announced that it will converge Canadian GAAP with International Financial Reporting Standards (IFRSs) over a transitional period for Canadian public companies. Australia and the European Union have already adopted IFRS and other countries have convergence programs underway.



3.6 TAXES

Taxes paid to governments affect cash flow available for shareholders. Usually there is a tax implication for every financial decision. The basic tax concepts which follow will assist in making the “tax adjustments” needed for the financial decisions studied in future chapters.

Corporate Tax

A. The corporation is taxed on its taxable revenue adjusted for tax-deductible business expenses, such as cost of goods sold, salaries, interest paid, and so forth. The tax tables listed in Table 3.4 lists the federal and provincial tax rates for corporate taxable income.

B. Interest expense for the corporation is tax deductible; cash dividends paid to shareholders are not. The after-tax cost of a dollar of interest expense paid, with a 35 percent marginal tax bracket, is $1.00 times (1 - marginal tax rate of .35) or $.65. The cost of a $1.00 of dividends is $1.00, for dividends are not tax deductible. This special tax deduction for interest will have important implications when the financing decision of debt or equity is discussed.

Personal Tax

A. Interest income for individuals (not corporations) is taxed as ordinary income at the appropriate marginal tax rate. Both the federal government and each province charge its own taxes and have its own tax rates. See Table 3.6.

B. The marginal tax rate represents the added taxes per dollar owed for each additional dollar of taxable income. The marginal tax rate is the relevant tax rate for financial decision-making analysis. The concept is future oriented, consistent with financial decision-making.

C. The average tax rate represents the total taxes owed divided by income before taxes. The average tax rate is a historical, after-the-fact measure and not a valid decision-making tool.

D. Dividends are taxed at a rate lower than salary or interest income. The Canadian tax system recognizes that dividends are paid from a company’s after-corporate tax income. Individuals are given a tax credit, recognizing that some tax has already been paid. For federal taxes, the dividend tax credit is 13.33% of grossed-up dividends (16.67% of actual dividends). To calculate taxes on dividends, dividends are first grossed up the gross-up factor of 1.25. Gross federal taxes equal the tax rate times the grossed up dividend. Then the dividend tax credit is subtracted to give net federal taxes. The process is repeated with the appropriate provincial dividend tax credit and provincial tax rate to calculate the provincial dividend tax. See Example 3.2.

E.. Capital gains are taxed at one-half of the tax rate on salary and interest income. This applies to both personal and corporate capital gains. Capital gains are only taxable when realized (when the asset is sold for more than was originally paid to purchase it). See Example 3.3.

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