Chapter 3 Financial Statements

1. Chapter 3 Financial Statements

2. Chapter 3 Outline

3. 3.3 The Tax System Corporations are distinct legal entities and are taxed as such. Corporations file income tax returns with the Internal Revenue Service (IRS) that are determined in much the same way as corporations prepare their income statements for investors.

4. Tax issues: Interests and dividends Interest is fully taxable when received and fully deductible when paid. Dividends are not tax deductible when paid; they are paid out of after-tax income.

5. Depreciation for tax purposes • For tax purposes, the government requires a specific form of depreciation. In the United States, this method is the Modified Accelerated Cost Recovery System (MACRS), which is based on the following assumptions: • Using a 200% declining balance method (that is, the annual rate is 200% of what the straight-line rate would be for the same asset life) • Ignoring salvage value for purposes of depreciation • Employing the half-year convention in the first year, which means that only one-half of the first year’s depreciation is actually allowed the first year, resulting in an extra year of depreciation • Assigning prescribed lives, based on the type of asset. That is, an asset may be a 3-year MACRS asset or a 5-year MACRS asset (there is no 4-year MACRS asset). The taxpayer must look up the asset in the tax code to determine its MACRS life.

6. MACRS Source: U.S. Internal Revenue Code

7. MACRS Source: U.S. Internal Revenue Code

8. MACRS example:$10,000 cost, 5 year asset

9. Deferred taxes Deferred tax assets Deferred tax liability Tax expected to be paid in the future. e.g., MACRS for tax purposes but SL for financial reporting • Tax benefits company expects to receive in the future • e.g., net operating loss carryover

10. Capital Gains Capital gain - a taxable gain incurred when an asset is sold at a price greater than its original cost. Capital loss -a tax deductible loss generated when a non-depreciable asset is sold at a price lower than its original cost.

11. Capital gains and taxes Suppose you sell an asset for $8,000 that has a book value of $5,760. And suppose you paid $20,000 for this asset three years ago. If the tax rate on ordinary income is 25% and the tax on capital gains is 20%, what is the tax on this sale?

12. Capital gains and taxes, continued Because the sale price is less than the original cost, all of the gain is taxed as ordinary income (depreciation recapture)

13. Capital gains and taxes Suppose you sell an asset for $22,000 that has a book value of $5,760. And suppose you paid $20,000 for this asset three years ago. If the tax rate on ordinary income is 25% and the tax on capital gains is 20%, what is the tax on this sale?

14. Capital gains and taxes, continued Because the sale price is greater than the original cost, some of the gain is taxed as ordinary income (depreciation recapture) and some is taxed as capital gain.

15. Tax Rates The tax rate system in the United States is progressive, with increasing amounts of income taxed at higher rates. Consider the tax rate schedule:

16. Tax Rates Marginal tax rate = 35% Average tax rate = $3,750,000 ÷ $11,000,000 = 34.09%

17. Summary • Financial statements are prepared in accordance with a given set of guidelines or principles, which allow comparability across time for a given company and across companies. • Accounting principles allow some flexibility, which is important in having a uniform set of principles applied to companies in different industries and of different sizes. • However, this flexibility puts a burden on those analyzing the financial statements to appreciate the degree of flexibility and the possible effect on the reported financial statements.

18. Summary • The financial statements for a company are constructed based on entries throughout the period. • Because statements are a result of transactions that involve debits and credits, there are linkages among these statements that include the following: • The balance sheet provides the carrying value of assets, liabilities, and equity at apoint in time, whereas the income statement is a summary of the revenues and expensesover the period. • The statement of cash flows provides cash flows in terms of thethree primary sources/uses: operations, investment, and financing.

19. Summary • For financial reporting purposes, the management of the company may select among several different methods, including declining balance, sum-of-years’-digits, and straight-line. • For tax purposes, companies in the United States must use the MACRS system. • Income for accounting purposes is not likely to be equal to taxable income because of differences in accounting for revenues and expenses. • These differences may give rise to deferred assets (tax benefits to be received in the future) or deferred taxes (tax obligations to be paid in the future).