CHAPTER 2 REVIEWING FINANCIAL STATEMENTS

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CHAPTER 2 – REVIEWING FINANCIAL STATEMENTS

Questions

LG2-1 1. List and describe the four major financial statements.

The four basic financial statements are:

• The balance sheet reports a firm’s assets, liabilities, and equity at a particular point in time.
• The income statement shows the total revenues that a firm earns and the total expenses the

firm incurs to generate those revenues over a specific period of time—generally one year.

• The statement of cash flows shows the firm’s cash flows over a given period of time. This

statement reports the amounts of cash the firm generated and distributed during a particular time period. The bottom line on the statement of cash flows―the difference between cash sources and uses―equals the change in cash and marketable securities on the firm’s balance sheet from the previous year’s balance.

• The statement of retained earnings provides additional details about changes in retained

earnings during a reporting period. This financial statement reconciles net income earned during a given period minus any cash dividends paid within that period to the change in retained earnings between the beginning and ending of the period.

LG2-1 2. On which of the four major financial statements (balance sheet, income statement, statement of cash flows, or statement of retained earnings) would you find the following items?

• earnings before taxes - income statement
• net plant and equipment - balance sheet
• increase in fixed assets - statement of cash flows
• gross profits - income statement
• balance of retained earnings, December 31, 20xx - statement of retained earnings and balance

sheet

• common stock and paid-in surplus - balance sheet
• net cash flow from investing activities - statement of cash flows
• accrued wages and taxes – balance sheet
• increase in inventory - statement of cash flows

LG2-1 3. What is the difference between current liabilities and long-term debt?

Current liabilities constitute the firm’s obligations due within one year, including accrued wages and taxes, accounts payable, and notes payable. Long-term debt includes long-term loans and bonds with maturities of more than one year.

LG2-1 4. How does the choice of accounting method used to record fixed asset depreciation affect management of the balance sheet?

(Finance Applications & Theory, 6e Marcia Cornett, Troy Adair, John Nofsinger) (Solution Manual, For Complete File, Download link at the end of this File) 1 / 4

Chapter 2 - Reviewing Financial Statements

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.Firm managers can choose the accounting method they use to record depreciation against their fixed assets. Two choices include the straight-line method and the modified accelerated cost recovery system (MACRS). Companies often calculate depreciation using MACRS when they figure the firm’s taxes and the straight-line method when reporting income to the firm’s stockholders. The MACRS method accelerates deprecation, which results in higher depreciation expenses, lower taxable income, and lower taxes in the early years of a project’s life. The straight-line method results in lower depreciation expenses, but also results in higher taxes in the early years of a project’s life. Firms seeking to lower their cash outflows from tax payments will favor the MACRS depreciation method.

LG2-1 5. What is bonus depreciation? How did the Tax Cuts and Jobs Act of 2017 temporarily extend and modify bonus depreciation?Since 2001, businesses have had the ability to immediately deduct a percentage of the acquisition cost of qualifying assets as "bonus depreciation." This additional depreciation deduction was allowed to encourage business investment. However, bonus depreciation was a temporary provision; the rate would have been 50 percent in 2017, 40 percent in 2018, and 30 percent in 2019, before phasing out in 2020. The Tax Cuts and Jobs Act of 2017 extended and modified bonus depreciation, allowing businesses to immediately deduct 100 percent of the cost of eligible property in the year it is placed in service, through 2022. The amount of allowable bonus depreciation will then be phased down over four years: 80 percent will be allowed for property placed in service in 2023, 60 percent in 2024, 40 percent in 2025, and 20 percent in 2026.MACRS or straight-line depreciation is applied to any costs that do not qualify for bonus depreciation.

LG2-1 6. What are the costs and benefits of holding liquid securities on a firm’s balance sheet?

The more liquid assets a firm holds, the less likely the firm will be to experience financial distress. However, liquid assets generate little or no profits for a firm. For example, cash is the most liquid of all assets, but it earns little, if any, return for the firm. In contrast, fixed assets are illiquid, but provide the means to generate revenue. Thus, managers must consider the trade-off between the advantages of liquidity on the balance sheet and the disadvantages of having money sit idle rather than generating profits.

LG2-2 7. Why can the book value and market value of a firm differ?

A firm’s balance sheet shows its book (or historical cost) value based on Generally Accepted Accounting Principles (GAAP). Under GAAP, assets appear on the balance sheet at what the firm paid for them, regardless of what assets might be worth today if the firm were to sell them.Inflation and market forces make many assets worth more now than they were when the firm bought them. So in most cases, book values differ widely from the market values for the same assets—the amount that the assets would fetch if the firm actually sold them. For the firm’s current assets—those that mature within a year―the book value and market value of any particular asset will remain very close. For example, the balance sheet lists cash and marketable 2 / 4

Chapter 2 - Reviewing Financial Statements

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.securities at their market value. Similarly, firms acquire accounts receivable and inventory and then convert these short-term assets into cash fairly quickly, so the book value of these assets is generally close to their market value.

LG2-2 8. From a firm manager’s or investor’s point of view, which is more important―the book value of a firm or the market value of the firm?

Balance sheet assets are listed at historical cost. Managers would thus see little relation between the total asset value listed on the balance sheet and the current market value of the firm’s assets.Similarly, the stockowners’ equity listed on the balance sheet generally differs from the true market value of the equity—in this case, the market value may be higher or lower than the value listed on the firm’s accounting books. So, financial managers and investors often find that balance sheet values are not always the most relevant numbers.

LG2-3 9. How did the Tax Cuts and Jobs Act of 2017 change corporate tax laws?

The Tax Cuts and Jobs Act (TCJA) of 2017 is the most recent revision of corporate tax laws and represents one of the most significant changes in more than 30 years. The Act permanently lowers corporate taxes from a progressive schedule that saw tax rates as high as 35 percent to a flat 21 percent starting in 2018.

LG2-3 10. What is the difference between an average tax rate and a marginal tax rate?

A firm can figure the average tax rate as the percentage of each dollar of taxable income that the firm pays in taxes. From your economics classes, you can probably guess that the firm’s marginal tax rate is the amount of additional taxes a firm must pay out for every additional dollar of taxable income it earns.

LG2-3 11. How did the Tax Cuts and Jobs Act of 2017 change the tax deductibility of corporate interest in debt?

The Tax Cuts and Jobs Act of 2017 contains a new limitation on the deductibility of net interest expense (interest expense minus interest income) that exceeds 30 percent of a firm’s “adjusted taxable income” starting in 2018. For tax years beginning before January 1, 2022, “adjusted taxable income” is measured as a business’ EBITDA. For subsequent tax years, “adjusted taxable income” is measured as EBIT, no longer including an add-back for depreciation and amortization. Thus, beginning in 2022, the new limitation will become more severe. Prior corporate tax laws generally allowed full deduction of interest paid or accrued by businesses.

LG2-3 12. How does the payment of interest on debt affect the amount of taxes the firm must pay?

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Chapter 2 - Reviewing Financial Statements

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.Corporate interest payments appear on the balance sheet as an expense item, so we deduct the allowable portion of interest payments from operating income when the firm calculates taxable income. But any dividends paid by corporations to their shareholders are not tax deductible. This is one factor that encourages managers to finance projects with debt financing rather than to sell more stock. Suppose one firm uses mainly debt financing and another firm, with identical operations, uses mainly equity financing. The equity-financed firm will have very little interest expense to deduct for tax purposes. Thus, it will have higher taxable income and pay more taxes than the debt-financed firm. The debt-financed firm will pay fewer taxes and be able to pay more of its operating income to asset funders, i.e., its bondholders and stockholders. So, as long as interest on debt is under the 30 percent allowable cap for tax deduction, even stockholders prefer that firms finance assets primarily with debt rather than with stock.

LG2-4 13. The income statement is prepared using GAAP. How does this affect the reported revenue and expense measures listed on the balance sheet?

Company accountants must prepare firm income statements following GAAP principles. GAAP procedures require that the firm recognize revenue at the time of sale, but sometimes the company receives the cash before or after the time of sale. Likewise, GAAP counsels the firm to show production and other expenses on the balance sheet as the sales of those goods take place.So production and other expenses associated with a particular product’s sale only appear on the income statement (for example, cost of goods sold and depreciation) when that product sells. Of course, just as with the revenue recognition, actual cash outflows incurred with production may occur at a very different point in time—usually much earlier than GAAP principles allow the firm to formally recognize the expenses. Further, income statements contain several non-cash entries, the largest of which is depreciation. Depreciation attempts to capture the non-cash expense incurred as fixed assets deteriorate from the time of purchase to the point when those assets must be replaced. Let’s illustrate the effect of depreciation: Suppose a firm purchases a machine for $100,000. The machine has an expected life of five years and at the end of those five years, the machine will have no expected salvage value. The firm lays out a $100,000 cash outflow at the time of purchase. But the entire $100,000 does not appear on the income statement in the year that the firm purchases the machine—in accounting terms, the machine is not expensed in the year of purchase. Rather, if the firm’s accounting department uses the straight- line depreciation method, it deducts only $100,000/5, or $20,000, each year as an expense. This $20,000 equipment expense is not a cash outflow for the firm. The person in charge of buying the machine knows that the cash flow occurred at the time of purchase—and it totaled $100,000 rather than $20,000. So, figures shown on an income statement may not represent the actual cash inflows and outflows for a firm during a particular period.

LG2-4 14. Why do financial managers and investors find cash flows to be more important than accounting profit?

Financial managers and investors are far more interested in actual cash flows than they are in the somewhat artificial, backward-looking accounting profit listed on the income statement. This is a very important distinction between the accounting point of view and the finance point of view.

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