978-0077861704 Chapter 2 Lecture Note

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Chapter 02 – Financial Statements, Taxes, and Cash Flow

Chapter 2

FINANCIAL STATEMENTS, TAXES, AND CASH FLOW

CHAPTER WEB SITES

Section Web Address

2.1 finance.yahoo.com

money.cnn.com

finance.google.com

disney.go.com

www.sec.gov

www.fasb.org

2.3 www.irs.gov

CHAPTER ORGANIZATION

2.1 The Balance Sheet

Assets: The Left Side

Liabilities and Owners’ Equity: The Right Side

Net Working Capital

Liquidity

Debt versus Equity

Market Value versus Book Value

2.2 The Income Statement

GAAP and the Income Statement

Noncash Items

Time and Costs

2.3 Taxes

Corporate Tax Rates

Average versus Marginal Tax Rates

2.4 Cash Flow

Cash Flow from Assets

Cash Flow to Creditors and Stockholders

An Example: Cash Flows for Dole Cola

2.5 Summary and Conclusions

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Chapter 02 – Financial Statements, Taxes, and Cash Flow

ANNOTATED CHAPTER OUTLINE

1. The Balance Sheet

A. Assets: The Left Side

Assets are divided into several categories. Make sure that students

recall the difference between current and fixed assets, as well as

tangible and intangible assets.

B. Liabilities and Owners’ Equity: The Right Side

The right-hand side is categorized by the firm’s debt and

ownership. Make sure that students recall the difference between

current and long-term liabilities.

Recall the balance sheet identity:

assets = liabilities + owners’ equity

Lecture Tip: Students sometimes find it difficult to see the

relationship between the decisions made by financial managers

and the values that subsequently appear on the firm’s balance

sheet. One way to help them see the “big picture” is to emphasize

that all finance decisions are either investment decisions or

financing decisions. Investment decisions involve the purchase

and sale of any assets (not just financial assets). Investment

decisions show up on the left-hand side of the balance sheet.

Financing decisions involve the choice of whether to borrow

money to buy the assets or to issue new ownership shares.

Financing decisions show up on the right-hand side of the balance

sheet.

Lecture Tip: You may find it useful at this point to spend a few

minutes reinforcing the concepts of owners’ equity and retained

earnings. The students should recall that owners’ equity consists of

the common stock account, paid-in surplus, and treasury stock. It

is important to remind students that the firm’s net income belongs

to the owners. It can either be paid out in dividends or reinvested

in the firm. When it is reinvested in the firm, it becomes additional

equity investment and shows up in the retained earnings account.

C. Net Working Capital

The difference between a firm’s current assets and its current

liabilities.

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Chapter 02 – Financial Statements, Taxes, and Cash Flow

Assets are listed on a balance sheet in order of how long it takes to

convert them to cash. Liability order reflects time to maturity.

D. Liquidity

It is important to point out to students that liquidity has two

components: how long it takes to convert to cash and the value that

must be relinquished to convert to cash quickly. Any asset can be

converted to cash quickly if you are willing to lower the price

enough.

It is also important to point out that more-liquid assets also provide

lower returns. Consequently, too much liquidity can be just as

detrimental to shareholder wealth maximization as too little

liquidity.

Lecture Tip: Some students get a little confused when they try to

understand that excessive cash holdings can be undesirable.

Occasionally, they leave an accounting principles class with the

belief that a large current ratio is, in and of itself, a good thing.

Short-term creditors like a company to have a large current ratio,

but that doesn’t mean that excess cash is good for the firm.

You may wish to mention that a cash balance is a use of funds and,

therefore, has an opportunity cost. Ask what a company could do

with cash if it were not sitting idle. It could be paid to

stockholders, invested in productive assets, or used to reduce debt.

Students need to understand that a change in a firm’s cash account

is not the same as cash flow, regardless of what the “Statement of

Cash Flows” may imply.

E. Debt versus Equity

Interest and principal payments on debt have to be paid before cash

may be paid to stockholders. The company’s gains and losses are

magnified as the company increases the amount of debt in the

capital structure. This is why we call the use of debt “financial

leverage.”

The balance sheet identity can be rewritten to illustrate that

owners’ equity is just what’s left after all debts are paid.

owners’ equity = assets – liabilities

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Chapter 02 – Financial Statements, Taxes, and Cash Flow

F. Market Value versus Book Value

Book values are generally not all that useful for making decisions

about the future because of the historical nature of the numbers.

Also, some of the most important assets and liabilities don’t show

up on the balance sheet. For example, the people that work for a

firm can be very valuable assets, but they aren’t included on the

balance sheet. This is especially true in service industries.

Lecture Tip: Accounting, or historical costs, are not very

important to financial managers, while market values are. Some

students have difficulty recognizing that the passage of time and

changing circumstances will almost always mean that the price an

asset would fetch if sold today is quite different from its book

value. Sometimes an example or two of familiar instances are

enough to make the point. For example, pointing out the

differences between market values and historical costs of used cars

and houses may help.

Some students recognize the difference between book values and

market values, but do not understand why market values are the

more important numbers for decision-making. The simplest answer

is that market value represents the cash price people are willing

and able to pay. After all, it is cash that must ultimately be paid or

received for investments, interest, principal, dividends, and so

forth.

Lecture Tip: The above example also provides a rationale for the

accounting practice of “marking-to-market.” Firm value is better

reflected in the financial statements. However, students should be

reminded that this occurs with only a portion of the firm’s assets –

primarily marketable securities, inventory, and derivatives

positions. As such, it is unlikely that the aggregate balance sheet

values provided by the firm will accurately reflect market values,

even when prepared by the most scrupulous of accountants.

Lecture Tip: Finance practitioners (and professors) throw around

terms like “mid-cap,” “small-cap,” etc. But what is the generally

accepted definition of a “mid-cap” firm? According to CFO

magazine, “small-caps” are firms with market capitalization less

than $1 billion, “mid-caps” fall in the $1 billion to $5 billion

range, and “large-caps” have total market value of equity in

excess of $5 billion.

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Chapter 02 – Financial Statements, Taxes, and Cash Flow

2. The Income Statement

Lecture Tip: Previously, it was noted that investment decisions are

reflected on the left-hand side of the balance sheet and financing

decisions are reflected on the right-hand side of the balance sheet.

You could also point out that the income statement reflects

investment decisions in the “top half,” from sales to EBIT.

Financing decisions are reflected in the “bottom half,” from EBIT

to net income and earnings per share.

A. GAAP and the Income Statement

Remember that GAAP requires that we recognize revenue when it

is earned, not when the cash is received and we match costs to

revenues. This introduces noncash deductions such as depreciation

and amortization. Consequently, net income is NOT the same as

cash flow.

Lecture Tip: In March 2004, Global Crossing reported record

quarterly earnings of $24.88 billion on revenues of $719 million.

These earnings came about because of GAAP rules regarding non-

cash items related to the firm’s emergence from bankruptcy.

According to The Wall Street Journal Online (Global Crossing

Scores A Bankruptcy Bonanza, March 11, 2004), $8 billion of the

profit came from the ability to eliminate the liabilities associated

with contracts with equipment vendors that were renegotiated

during bankruptcy. Another $16 billion came from eliminating

common and preferred shares that previously existed. The

remainder of the “profit” came from the liabilities associated with

contracts between Global Crossing and other phone companies

that were eliminated during the bankruptcy proceedings. If these

non-cash “revenues” were eliminated from the calculations, then

the firm would have had a net loss of approximately $3 million.

Clearly, GAAP will not always provide a clear view of a firm’s

earnings.

Ethics Note: Publicly traded firms have to file audited annual

reports, but that doesn’t mean that “accounting irregularities”

never slip by the auditors. Companies that deliberately

manipulate financial statements may benefit in the short run, but it

eventually comes back to haunt them. Cendant Corporation is a

good example. Cendant was created when CUC International and

HFS, Inc. merged in late 1997. The combined company owns

businesses in the real estate and travel industries. In April 1998,

the combined company announced that accounting irregularities

had been found in the CUC financial statements and earnings

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Chapter 02 – Financial Statements, Taxes, and Cash Flow

would need to be restated for 1997 and possibly 1995 and 1996 as

well. Cendant’s stock price dropped 47 percent the day after the

announcement was made (it was announced after the market

closed). The problems haunted Cendant throughout 1998. In July,

it was announced that the problem was much worse than originally

expected and the stock price plummeted again. By the end of July

1998, the stock price had dropped more than 60 percent below the

price before the original announcement. The company also had to

take a $76.4 million charge in the third quarter of 1998 for the

costs of investigating the accounting irregularities. Criminal

charges were filed against several former executives of CUC

International and several class action lawsuits were filed against

Cendant. The stock was trading around $41 per share prior to the

announcement and dropped to as low as $7.50 per share in

October 1998. The price finally started to rebound toward the end

of 2003, but the price as of November 4, 2004 ($22.10) was still

only about 54% of what it had been prior to the announcement.

Other companies, such as Enron, WorldCom, etc., and their

investors have fared much worse. There were a string of

accounting problems at the start of this century, and these, along

with the terrorist attacks, aided the market decline during the early

2000s.

B. Noncash Items

The largest noncash deduction for most firms is depreciation. It

reduces a firm’s taxes and its net income. Noncash deductions are

part of the reason that net income is not equivalent to cash flow.

Lecture Tip: Students sometimes fail to grasp the distinction

between the economic life of an asset, the useful life of an asset for

accounting purposes, and the useful life of an asset for tax

purposes. “Economic life” refers to the period of time that the

asset is expected to generate cash flows and must be considered

when capital budgeting decisions are made. “Useful life” for

accounting purposes is largely determined by the firm’s

accountants, with guidance from GAAP, and it affects the

depreciation expense on the balance sheets and income statements

that are used for business purposes. Useful life for tax purposes is

determined by the Internal Revenue Service and is based on

different asset categories. This is also important for capital

budgeting because it determines the tax consequences of

depreciation, which affects cash flow.

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Chapter 02 – Financial Statements, Taxes, and Cash Flow

C. Time and Costs

We need to plan for both short-run cash flows and long-run cash

flows. In the short-run, some costs are fixed regardless of output

and other costs are variable. In the long run, all costs are variable.

It is important to identify these costs when doing a capital

budgeting analysis.

Lecture Tip: Distinguishing between fixed and variable costs can

have important implications for estimating cash flows. It is

sometimes helpful to remind students that variable costs are cash

outflows that vary with the level of output, while fixed costs do not.

Another important thing to point out is that the definition of short

run and long run varies for different types of businesses.

3. Taxes

Lecture Tip: The text notes the ever-changing nature of the tax

code. This can be illustrated by the changes in the Investment Tax

Credit (ITC) between 1962 and 1986.

1962 – Seven percent ITC created to stimulate capital investment

1966 – ITC suspended

1967 – Seven percent ITC reinstated

1969 – ITC eliminated

1971 – Seven percent ITC reinstated

1975 – Credit increased to 10 percent

1986 – ITC eliminated

A. Corporate Tax Rates

It’s important to point out to students that corporations (and

individuals) do not pay a flat rate on their income, but corporate

rates are not strictly increasing either.

B. Average versus Marginal Tax Rates

The average rate rises to the marginal rate at $50 million of taxable

income. The “surcharges” at 39% and 38% offset the initial lower

marginal rates.

Lecture Tip: It is useful to stress the situations in which marginal

tax rates are relevant and those in which average tax rates are

relevant. For purposes of computing a company’s total tax

liability, the average tax rate is the correct rate to apply to before

tax profits. However, in evaluating the cash flows that would be

generated from a new investment, the marginal tax rate is the

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Chapter 02 – Financial Statements, Taxes, and Cash Flow

appropriate rate to use. This is because the new investment will

generate cash flows that will be taxed above the company’s

existing profit.

Lecture Tip: The op-ed page of the March 11, 1998, issue of The

Wall Street Journal contains an article guaranteed to generate

class discussion. In “Abolish the Corporate Income Tax,” the

author provides a quick overview of the situation that brought the

current income tax into being in the early 1900s, and contends that

the corporate and personal income tax systems began life as “two

separate and completely uncoordinated tax systems.” With the

passage of time, the tax code has, of course, become extremely

complex and the author illustrates this by noting that “Chrysler

Corporation’s tax returns comprise stacks of paper six feet high,

prepared by more than 50 accountants who do nothing else.” And,

he points out, “the Internal Revenue Service, meanwhile, has a

team of auditors who do nothing but monitor Chrysler’s returns.”

Given the complexity and wasted effort, the author suggests that

the rational thing to do is to abolish the corporate income tax. Do

you agree?

4. Cash Flow

A. Cash Flow from Assets (CFFA)

The cash flow identity is similar to the balance sheet identity:

Cash Flow from Assets = Cash Flow to Creditors + Cash Flow to

Stockholders

CFFA = Operating cash flow – net capital spending – changes in

net working capital

Operating cash flow (OCF) = EBIT + depreciation – taxes

Net capital spending (NCS) = ending fixed assets – beginning

fixed assets + depreciation

Changes in NWC = ending NWC – beginning NWC

B. Cash Flow to Creditors and Stockholders

Cash flow to creditors = interest paid – net new borrowing =

interest paid – (ending long-term debt – beginning long-term debt)

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Chapter 02 – Financial Statements, Taxes, and Cash Flow

Cash flow to stockholders = dividends paid – net new equity raised

= dividends paid – (ending common stock, APIC, & Treasury stock

– beginning common stock, APIC, & Treasury stock)

It is important to point out that changes in retained earnings are not

included in “net new equity raised.” The effect of this increase is

captured in changes in net working capital and net capital

spending.

C. An Example: Cash Flows for Dole Cola

Lecture Tip: Textbooks make financial statement analysis seem

reasonably straightforward. However, it is not always as easy to

classify the numbers that appear on the consolidated financial

statements of an actual corporation. Consider the 2010 McGraw-

Hill Annual Report.

You can go to the McGraw-Hill web site (http://www.mcgraw-

hill.com) and look under investor relations to get the most recent

annual report available.

The following questions may arise from looking at the financial

statements:

1. How do you account for “prepublication costs,” “investments

and other assets” and “goodwill and other intangible assets?” Are

they included in net capital spending or are they accounting

numbers with no real impact on cash flows?

2. How should the “other liabilities” be accounted for? Again,

which accounts truly provide changes in cash flows and which

accounts are just used for accounting purposes without an actual

change in cash flows.

3. How do “accumulated other comprehensive income” and

“unearned compensation on restricted stock” affect cash flows?

The cash flow identity does not appear to hold when applied in a

reasonable fashion based on the information provided. It is

important to point out that financial managers have a lot more

information available to them than what is provided in the

consolidated statements of an annual report. The manager will

have the information available to compute cash flow from assets

and, if it is done carefully, the cash flow identity will hold.

5. Summary and Conclusions

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