CFIN 300 Chapter 2 â Financial Statements, Cash Flow, and Taxes ...
CFIN 300 Chapter 2 – Financial Statements, Cash Flow, and Taxes 2.1 – Statement of Financial Position Statement of Financial Position – financial statement showing a firm’s accounting value on a particular date. Also known as a balance sheet. Assets, Liabilities, Equity (Difference between assets and liabilities) International Financial Reporting Standards (IFRS) Assets Current o Life of less than 1 year (convert to cash within a year) Fixed o Tangible/Intangible o Capital Assets Liabilities and Owner’s Equity Current o Less than 1 year (Paid within the year) LongTerm o Bond and bondholders refer to longterm debt and longterm creditors, respectively Shareholder’s equity o Difference between the total value of the assets and the total value of the liabilities Net Working Capital Difference between a firm’s current assets and its current liabilities Liquidity Refers to the speed and ease with which an asset can be converted to cash Two dimensions: o Ease of conversion o Loss of value High liquid = quickly sold without significant loss of value Illiquid asset = cannot be quickly converted to cash without a substantial price reduction The more liquid a company is, the less likely it is to experience financial distress Debt Versus Equity Equity holders are only entitled to the residual value Shareholders’ equity is defined as a residual portion Financial leverage – more debt a firm has, greater is its degree of financial leverage Value versus Cost
CFIN 300
Accounting value of a firm’s assets is referred to as carrying value/book value IFRS allows companies to use the historical cost method – use of the revaluation (fair value method) Market value – price at which willing buyers and sellers trade the assets
2.2 – Statement of Comprehensive Income Statement of comprehensive income – financial statement summarizing a firm’s performance over a period of time (income statement) Revenues – Expenses = Income Net Income (Bottom Line) o Often expressed on a pershare basis called earnings per share (EPS) Income is reported when it is earned or accrued, even though no cash flow has necessarily occurred NonCash Items NonCash Items – expenses charged against revenues that do not directly affect cash flow, such as depreciation Time and Costs Useful to think of the future as having two distinct parts o Short Run o Long Run Usually classify between product costs/period costs o Product costs = raw materials, direct labour expense, and manufacturing overhead o Period costs = incurred during a particular time period Reported as selling, general, and administrative expenses 2.3 – Cash Flow
Cash flow from assets = Cash flow to bondholders + Cash flow to shareholders
Cash Flow from Assets Cash Flow from Assets – the total of cash flow to bondholders and cash flow to shareholders, consisting of: operating cash flow, capital spending, and additions to net working capital o Operating Cash Flow – cash flow that results from the firm’s daytoday activities of producing and selling Revenues minus costs • Without depreciation, and interest • Includes taxes o Capital Spending – net spending on fixed assets less money received from the sale of fixed assets o Additions to net working capital – amount spend on net working capital
CFIN 300
Total Cash Flow from assets = Operating Cash Flow MINUS Capital Spending + Additions to NWC Free Cash Flow – another name for cash flow from assets
Cash Flow to Creditors and Shareholders Cash Flow to Creditors – a firm’s interest payments to creditors less net new borrowings Cash Flow to Shareholders – Dividends paid out by a firm less net new equity raises Cash flow from assets MUST EQUAL Cash flow to Creditors and shareholders 2.4 – Taxes Cash Flows measured after taxes Average tax rate – total taxes paid divided by total taxable income Marginal tax rate – amount of tax payable on the next dollar earned Any new cash flows are taxed at the marginal rate Taxes on Investment Income
Dividends in Canada have two clear goals o Corps. Pay dividends from aftertax income so tax laws shelter dividends from full tax in the hands of shareholders Diminishes double taxation o Dividend Tax Credit – tax formula that reduces the effective tax rate on dividends Applies only to dividends paid by Canadian corps o Capital Gains – the increase in value of an investment over its purchase price Lightly taxes Apply at 50 percent of the applicable marginal rate o Realized Capital Gains – increase in value of an investment, when converted to cash Reason why capital gains are lightly taxed
Corporate Taxes
Corporate taxes are passed on to consumers through higher prices, workers through lower wage, or to investors through lower returns
Capital Gains and Carryforward and Carryback Loss carryforward, carryback – using a year’s capital losses to offset capital gains in past or future years If capital losses exceed capital gains, the net capital loss may be carried back to reduce taxable capital gains in the three prior years Files a revised tax return and receives a refund of prior years’ taxes
CFIN 300
Carry forward – applies to operating losses (allowed up to 7 years)
2.5 – Capital Cost Allowance Capital Cost Allowance – depreciation for tax purposes, not necessarily the same as depreciation under IFRS Deducted in determining income Company is allowed to use accelerated CCA rules in computing depreciation for tax purposes Assigning every capital asset to a particular class o Asset’s class establishes its maximum CCA rate for tax purposes Intangible assets follow straightline depreciation All other assets follow declining balance method CCA for each year is computed by multiplying the asset’s book value for tax purposes, called Undepreciated Capital Cost (UCC) HalfYear Rule – CRA’s requirement to figure CCA on only onehalf of an asset’s installed cost for its first year of use Asset Purchases and Sales
When asset is sold, UCC in its asset class is reduced by what is realized on the asset or by its original cost, whichever is less o Adjusted Cost of Disposal Net Acquisition – total installed cost of capital acquisitions minus adjusted cost of any disposals within an asset pool o Result is net acquisitions for the asset class If + • Apply Half Year Rule and calculate CA If – • No adjustment for Half Year Rule
When an Asset Pool is Terminated
A positive or negative UCC remains and has tax implications A positive UCC balance remains when the adjusted cost of disposal is less than UCC o Terminal loss – difference between UCC and adjusted cost of disposal when the UCC is greater A negative UCC balance occurs when the adjusted cost of disposal exceeds UCC, in the pool o Must pay tax at its ordinary tax rate o Difference in adjusted cost of disposal and UCC is excess CCA recaptured Recaptured Depreciation – taxable difference between adjusted cost of disposal and UCC when UCC is smaller
CFIN 300
CFIN 300
Accounting value of a firm’s assets is referred to as carrying value/book value IFRS allows companies to use the historical cost method – use of the revaluation (fair value method) Market value – price at which willing buyers and sellers trade the assets
2.2 – Statement of Comprehensive Income Statement of comprehensive income – financial statement summarizing a firm’s performance over a period of time (income statement) Revenues – Expenses = Income Net Income (Bottom Line) o Often expressed on a pershare basis called earnings per share (EPS) Income is reported when it is earned or accrued, even though no cash flow has necessarily occurred NonCash Items NonCash Items – expenses charged against revenues that do not directly affect cash flow, such as depreciation Time and Costs Useful to think of the future as having two distinct parts o Short Run o Long Run Usually classify between product costs/period costs o Product costs = raw materials, direct labour expense, and manufacturing overhead o Period costs = incurred during a particular time period Reported as selling, general, and administrative expenses 2.3 – Cash Flow
Cash flow from assets = Cash flow to bondholders + Cash flow to shareholders
Cash Flow from Assets Cash Flow from Assets – the total of cash flow to bondholders and cash flow to shareholders, consisting of: operating cash flow, capital spending, and additions to net working capital o Operating Cash Flow – cash flow that results from the firm’s daytoday activities of producing and selling Revenues minus costs • Without depreciation, and interest • Includes taxes o Capital Spending – net spending on fixed assets less money received from the sale of fixed assets o Additions to net working capital – amount spend on net working capital
CFIN 300
Total Cash Flow from assets = Operating Cash Flow MINUS Capital Spending + Additions to NWC Free Cash Flow – another name for cash flow from assets
Cash Flow to Creditors and Shareholders Cash Flow to Creditors – a firm’s interest payments to creditors less net new borrowings Cash Flow to Shareholders – Dividends paid out by a firm less net new equity raises Cash flow from assets MUST EQUAL Cash flow to Creditors and shareholders 2.4 – Taxes Cash Flows measured after taxes Average tax rate – total taxes paid divided by total taxable income Marginal tax rate – amount of tax payable on the next dollar earned Any new cash flows are taxed at the marginal rate Taxes on Investment Income
Dividends in Canada have two clear goals o Corps. Pay dividends from aftertax income so tax laws shelter dividends from full tax in the hands of shareholders Diminishes double taxation o Dividend Tax Credit – tax formula that reduces the effective tax rate on dividends Applies only to dividends paid by Canadian corps o Capital Gains – the increase in value of an investment over its purchase price Lightly taxes Apply at 50 percent of the applicable marginal rate o Realized Capital Gains – increase in value of an investment, when converted to cash Reason why capital gains are lightly taxed
Corporate Taxes
Corporate taxes are passed on to consumers through higher prices, workers through lower wage, or to investors through lower returns
Capital Gains and Carryforward and Carryback Loss carryforward, carryback – using a year’s capital losses to offset capital gains in past or future years If capital losses exceed capital gains, the net capital loss may be carried back to reduce taxable capital gains in the three prior years Files a revised tax return and receives a refund of prior years’ taxes
CFIN 300
Carry forward – applies to operating losses (allowed up to 7 years)
2.5 – Capital Cost Allowance Capital Cost Allowance – depreciation for tax purposes, not necessarily the same as depreciation under IFRS Deducted in determining income Company is allowed to use accelerated CCA rules in computing depreciation for tax purposes Assigning every capital asset to a particular class o Asset’s class establishes its maximum CCA rate for tax purposes Intangible assets follow straightline depreciation All other assets follow declining balance method CCA for each year is computed by multiplying the asset’s book value for tax purposes, called Undepreciated Capital Cost (UCC) HalfYear Rule – CRA’s requirement to figure CCA on only onehalf of an asset’s installed cost for its first year of use Asset Purchases and Sales
When asset is sold, UCC in its asset class is reduced by what is realized on the asset or by its original cost, whichever is less o Adjusted Cost of Disposal Net Acquisition – total installed cost of capital acquisitions minus adjusted cost of any disposals within an asset pool o Result is net acquisitions for the asset class If + • Apply Half Year Rule and calculate CA If – • No adjustment for Half Year Rule
When an Asset Pool is Terminated
A positive or negative UCC remains and has tax implications A positive UCC balance remains when the adjusted cost of disposal is less than UCC o Terminal loss – difference between UCC and adjusted cost of disposal when the UCC is greater A negative UCC balance occurs when the adjusted cost of disposal exceeds UCC, in the pool o Must pay tax at its ordinary tax rate o Difference in adjusted cost of disposal and UCC is excess CCA recaptured Recaptured Depreciation – taxable difference between adjusted cost of disposal and UCC when UCC is smaller
CFIN 300
