Practical financial managment 7e LASHER chapter 2

Chapter 2 - Financial background: A Review of
Accounting, Financial Statements and Taxes


The Nature of Financial Statements
Numerical representations of a firm’s
activities for an accounting period
– A picture of activities within the firm and
between the firm and the outside
– But can be counterintuitive

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Accounts Receivable
Most sales are on credit
Seller receives a promise of later
payment, rather than immediate cash
The seller records an account receivable
as an asset
Net income may not = cash flow


Depreciation
Proration of an asset’s cost over its
service life
Can be straight lined or accelerated
Cost recorded on the income statement
does not = cash spent

The Nature of Financial Statements
Three Financial Statements
– Income statement
– Balance sheet
– Statement of cash flows
Generated from the income statement and
balance sheet

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The Accounting System
A firm’s financial books are a collection
of records in which money transactions
are recorded
– Double entry system
– Accounting periods and closing the books
– Implications
– Stocks and flows
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Table 2-1 A Typical Income Statement

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The Income Statement
Sales
Cost and Expenses

– Costs of Goods Sold
– Expense
– Depreciation
Gross margin
Earnings before interest and taxes (EBIT)
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The Income Statement
Earnings Before Tax, and Tax
Net Income
Terminology:
– Income = profit = earnings
– Profit before tax (PBT)
– Profit after tax (PAT)
– Earnings before tax (EBT)
– Earnings after tax (Net Income)
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Earnings
Earnings
– Also called net income
– Paid out as dividends or retained in business

Retained Earnings (RE)
– Each year earnings not paid as dividends
become an addition to equity
– Retained earnings account is cumulative
earnings not paid out as dividends

The Balance Sheet
Lists everything a company owns and
owes at a moment in time
– All sources and uses of money must be
equal

A firm’s money sources include creditors
and owners
– Borrowing creates a liability for repayment

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The Balance Sheet
Two equal sides
Assets = liabilities + equity

Assets and liabilities are arranged in
order of decreasing liquidity
Liquidity – ease with which an asset becomes or
a liability requires cash

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Table 2-2 A Conventional
Balance Sheet Format

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Assets
Cash

Accounts Receivable

Checking balances
plus currency

Uncollected credit sales

Marketable securities
are liquid investments
held instead of cash
– Short-term, modest
return, low risk

– Bad Debt Reserve:
some credit sales will
never be paid
– Write Off: Remove bad
debt from gross and
reserve leaving net
unchanged

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Concept Connection Example 2-1
Writing Off a Large Uncollectable Receivable
Gross accounts receivable
Bad-debt reserve

(290)

Net accounts receivable
Need to Write Off
Reserve

$5,650
$5,360

$435,000
290,000

Expense $145,000
Reestablish Reserve (5%)

260,750

Profit Reduction $405,750
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Assets
Inventory - product held for sale in the normal
course of business
– Work-In-Process Inventories (WIP)

Value added as inventory moves through production

– The Inventory Reserve
Some inventory is unusable - balances reported net of
reserve

– Writing Off Bad Inventory
Missing, damaged, or obsolete items removed from gross
and reserve leaving net unchanged
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Assets
Overstatements
– If assets are overstated, firm’s value is less than total
shown on balance sheet
Current Assets
– Become cash within a year
– Include cash, accounts receivable and

inventory

Fixed Assets
– Long lived, depreciable, also called property, plant and
equipment (PPE)
– Useful life of at least a year
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Assets

Depreciation
– Spreads asset’s cost over its estimated useful life

Financial Statement Representation
– Appears as an expense or cost
– Accumulated depreciation appears on balance
sheet reflecting a wearing out of the asset

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Table 2-3 Fixed Asset Depreciation

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Assets
Disposing of a Used Asset
The Life Estimate
Tax Depreciation and Tax Books
– Government allows different depreciation
schedules for tax purposes and financial
reporting purposes

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Concept Connection Example 2-2
Selling a Fixed Asset
Accounting

Revenue

Cash Flow

$4,000 $4,000

Cost (NBV)

2,500

Profit contribution: EBT
Tax (30%)

(450)

Contribution: net income
Cash flow

$1,500
(450)
$1,050

$3,550
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Liabilities
What a company owes to outsiders
Accounts Payable
– Arise when a firm buys from vendors on credit

Terms of Sale
– Specify when payment is due on credit sales and the
early payment discount

Understated Payables
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Liabilities
Accruals
– Recognize expenses and liabilities associated
with incomplete transactions
Payroll Accrual

Current Liabilities
– Require cash within one year
– Payable and accruals are classified as current
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Figure 2-1 A Payroll Accrual

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Working Capital

Total current assets = gross working capital

Net Working Capital = Current Assets ─ Current Liabilities

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