Accounting - The Language of Business: Learning Outcomes

INTRODUCTION
In this chapter we review key accounting topics that you

may have already encountered in a previous financial
accounting course, but here you will see the role of
accounting in a corporate finance setting. Although knowl-
edge of accounting is important in corporate finance, you
should note that the purpose of accounting is to understand how money has been spent.
The goal of finance is to understand how money should be spent in the future. We discuss
the main financial statementsincome statement, statement of retained earnings,
balance sheet, and cash flow statementwithin a financing framework, and examine
working capital and cash flow issues. Since taxation is an important fact to consider in
decision making, we discuss amortization, capital cost allowance, and the impact of each
on corporate taxes.
THE FUNDAMENTAL ACCOUNTING EQUATION
The fundamental accounting equation, also sometimes called the balance sheet equation,
is shown as Equation 2.1.
Assets Liabilities Shareholders equity 2.1
The balances of the individual components in this equation continually change in
order to keep the equation in balance. For example, assume that a company acquired a
new machine asset. In order to keep the fundamental accounting equation in balance,
C H A P T E R 2
Accounting
The Language
of Business
LEARNI NG OUTCOMES
When you have completed this chapter,
you should be able to:
1 Understand asset, liability, equity,
working capital, revenue, expense,
and dividend as accounting terms.
2 Contrast cash accounting with accrual
accounting, discuss the matching
principle, and explain the difference
between revenues and cash flows.
3 Explain the main purpose of each of
the four main financial statements
income statement, statement of
retained earnings, balance sheet,
and cash flow statement.
4 Explain the difference between amorti-
zation and capital cost allowance.
5 Describe how corporate taxes are
determined.
02Ch02_Atrill.QXD 2/29/08 9:57 AM Page 20
one or a combination of the following events must also simultaneously occur with the
new asset purchase:
1. Another asset balance must decrease, such as cash, if the machine is fully paid for
2. Liabilities must increase, such as accounts payable or loans payable, if the machine
is bought on credit
3. Shareholders equity must increase, such as common shares, if the machine is paid
for by issuing common shares to the seller.
Debits and Credits
Accountants generally do not speak in terms of accounts increasing or decreasing.
Instead, they debit (dr) or credit (cr) an account. From knowing what the normal sign
of an account is, accountants then know whether an account has increased or decreased.
You may recall from a previous accounting course that the terms debit and credit are not
value judgments (good or bad). Instead, debit simply means left and credit simply means
right. Figure 2.1 shows the fundamental accounting equation (Equation 2.1) with the
normal sign for each account category.
Chapter 2 AccountingThe Language of Business 21
Debits and credits add and subtract according to the following rules:
1. Two debits add to make a larger debit.
2. Two credits add to make a larger credit.
3. A debit and a credit subtract, with the remainder taking on the same sign as
the larger initial balance. For example, a $500 debit and a $700 credit to the same
account result in a $500 $700 = $200 credit balance in the account, because the
credit balance of $700 was larger than the $500 debit balance.
Accountants sometimes use T-accounts to compute an account balance. A T-account
looks like a T and simply divides the page between the left side (debit) and right side
(credit), so debits and credits can more easily be added and subtracted. A T-account
using data from the third rule above looks like this:
FIGURE 2.1 Normal Signs of Categories in the Fundamental Accounting Equation
Assets Liabilities Shareholders Equity
Normal sign Debit Credit Credit
Increase an account balance Debit Credit Credit
Decrease an account balance Credit Debit Debit
Liabilities
Debit side Credit side
Opening balance 700
Decrease 500
Closing balance 200
SIGNIFICANT ACCOUNTING TERMS
Asset
An asset is anything the company owns that is expected to provide future benefits.
Assets may be tangible (such as land, buildings, furniture, and fixtures) or intangible
(such as patents, copyrights, or trademarks). Current assets include cash, as well as other
items that are expected to be turned into cash in less than one year (such as accounts
receivable and inventory). Also included in current assets are regular expenses that have
been prepaid with cash (such as prepaid rent or prepaid insurance).
In contrast to current assets, long-term assets last longer than one year. Long-term
assets are sometimes also called capital assets, non-current assets, fixed assets, or
property, plant, and equipment. A company with extra cash available may convert it to
a long-term asset by acquiring bonds or shares of another company in order to earn a
higher return. Thus a company (or individual) may own a bond asset with the intention
of holding it to maturity and receiving semi-annual interest payments throughout
that time.
Asset accounts usually have a debit balance. For example, accounts for cash, land,
buildings, and equipment will all have a debit balance. However, if a company uses all
of its cash and draws on its bank overdraft position, then cash will cross the line
into credit or negative territory and appear on the balance sheet as a current liability.
A contra-asset, like accumulated amortization, is unusual because it has a credit
balance. However, it is still grouped with the assets because it represents the total
amount of amortization or depreciation subtracted from an asset. Remember that, for
example, equipment debits and equipment accumulated amortization credits subtract
to leave a net equipment debit balance.
Liability
A liability is an amount that the company owes. If a company must deliver cash to an
outside party at some point in the future, this is a liability. Liability accounts have a
credit balance. A current liability must be paid within one year. Examples of current
liabilities include accounts payable, accrued wages and salaries payable, and income
taxes payable. Typical examples of long-term liabilities, with due dates longer than one
year, are bank loans payable, bonds and debentures payable, and mortgages payable.
Shareholders Equity
A corporations shareholders equity includes contributed capital and retained
earnings. These accounts typically have credit balances, although if a corporation has
incurred larger losses than profits throughout its history, the retained earnings will be
in a deficit (negative) position and have a debit balance. Contributed capital consists
mainly of common shares and preferred shares. Some preferred shares are classified as
a liability on the balance sheet if the issuing company will most likely be forced to
redeem them in the future because of very onerous provisions, such as rapidly increas-
ing dividend payments. Remember, any time that a company will likely have to deliver
cash in the future to outside interests, it has a liability. In this case, accounting reports
the substance of a transaction, preferred share liability, and not the legal name of a
transaction, preferred share equity. The common share account consists of net cash
amounts received by the company from its owners, the shareholders, upon the sale of
its shares. The retained earnings account generally is the accumulated total of all the
22 Chapter 2 AccountingThe Language of Business
L.O. 1
net income or earnings the company has made since its inception minus the total of all
dividends paid to shareholders.
Sometimes a company will use excess cash to buy back its own shares in the
marketplace, especially when it feels that its shares are undervalued in the stock mar-
ket. This transaction reduces both cash and common shares. It should also provide a
boost to earnings per share as the number of shares outstanding is reduced. We will see
the calculation of earnings per share below the income statement in the Red River Ltd.
financial statements in the following pages. We will also encounter more on share
repurchases in Chapter 11.
Working Capital
Working capital is defined as current assets less current liabilities.
Working capital Current assets Current liabilities 2.2
Working capital is a measure of the cash available to the company during the next year,
and might suggest a need for further borrowing if working capital is too low. Working
capital will be discussed again in Chapter 4 when we study financial ratios.
Revenues
Revenues include sales of the companys goods and fees charged for services performed.
Revenue accounts have credit balances and may be thought of as helping to increase
retained earnings, which normally has a credit balance. (Remember, two credits add to
produce a larger credit.) It is very important for revenues to be entered into the books
in the correct accounting period. Companies are sometimes tempted to illegally speed
up the reporting of future revenues by reporting them in the current accounting peri-
od. This happened at Nortel Networks, causing several reissuings of the companys
financial statements.
Expenses
It is sometimes helpful to think of expenses as assets that were used up in the account-
ing period being reviewed. Expenses have debit balances and may be thought of as
reducing retained earnings, which has a credit balance. Expenses should include all the
costs incurred in order to produce the revenues for that accounting period. This
includes the cost of goods sold, selling expenses, and administrative expenses, as well
as amortization expense, interest expense, and income tax expense. As with revenues,
it is important for expenses to be reported in the correct accounting period.
Companies might be tempted to underreport expenses by sliding them into future
periods, thereby increasing net income for the current period.
Dividends
Dividends are a transfer of assets (usually cash payments) made by a business to its
owners, the shareholders. Dividends are debits and reduce the retained earnings. The
total amount of retained earnings is usually the maximum amount of dividends that
may be declared by the board of directors. You will learn more about dividend policy
in Chapter 11.
ACCRUAL ACCOUNTING, CASH FLOWS,
AND THE MATCHING PRINCIPLE
Probably the earliest accounting systems simply recorded cash transactions because
credit had not yet been invented. Once credit was established, an agreement had to be
established on whether to report the revenue when the sale occurred or when the cash
was collected. Accountants eventually agreed to report all revenues when the goods
were delivered to or picked up by the customer. In the case of services, the revenue is
generally earned when the service is completed. The extension of credit and the collec-
tion of cash related to a sale is a financing issue, not a revenue issue. Accrual account-
ing involves reporting a sale when the customer receives the goods or services without
regard to when the cash is actually collected. So, a sale on credit is just as good as a cash
sale, as far as revenue reporting is concerned.
Similarly, under accrual accounting principles, expenses are reported in the period
when incurred, whether or not the cash is paid. Amortization expense never directly
involves cash but must continue to be reported; it is an apportionment of the cost of a
capital asset over many years. For example, amortization expense on a factory building with
a 25-year estimated useful economic life is reported in the current years income statement,
even though it was acquired for cash 20 years ago. The factory was used to produce
products that were sold to generate revenue in the current period, so the amortization
expense is reported. See Example 2.1 for a comparison of cash flows and expenses.
Many calculations for decision making purposes in finance require the use of cash
flows. Therefore non-cash items, such as amortization expense, require us to make
special adjustments to accounting data in order to make it useful for finance. One such
adjustment is to add back amortization expense to net income to obtain cash flows.
Furthermore, the formal accounting cash flow statement is concerned with the past years
events, while cash flows in finance are for the most part concerned with the future. For
example, in determining whether a company should acquire a new machine, we need to
estimate the future cash flows for each year over the estimated useful life of the machine
based on future sales of products the machine will produce.
Another very important idea in accounting is the matching principle: expenses are
matched to revenues. In every accounting period, expenses incurred in that period to
achieve those revenues are reported. The matching principle is the reason why it is very
important to slot revenues and expenses into the correct accounting period prior to
preparing the financial statements.
L.O. 2
Example 2.1
Fizzy Drinks paid $3 million cash on January 2, Year 1, to buy an empty warehouse. Company executives
assign $1 million of the purchase price to the land on which the building stands and $2 million to the
building. The building is expected to last 20 years, at which time it will be replaced with a new building
on the same land. Fizzys year-end is December 31, Year 1.
The expense for Year 1 associated with this purchase is not equal to the $3 million cash paid. Since
land is considered not to wear out, except for a mining or oil and gas company, there is no expense
related to the $1 million cost of the land. The only expense is the amortization expense associated with
spreading the cost of the building over the 20 years of its expected useful life. One way to report amor-
tization expense is to make it equal for every year. This is called straight-line amortization, and in this
case it amounts to $2 million 20 years $100,000 per year for 20 years. So by accrual accounting
standards, there is a $100,000 expense every year for 20 years even though cash was involved only in
the first year, as shown in Table 2.1.
TABLE 2.1 Cash Flows Versus Expenses for Fizzys Warehouse Purchase
($ millions)
Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Cash Flows
Land 1.0
Building 2.0
Expenses
Amortization
expense 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1
ACTIVITY 2.1
Fizzy, with a year-end of December 31, sold $300,000 of goods on December 15, Year 1. The
terms of the sale included delivery of half the goods on December 30 and the remainder on
January 15, Year 2. The terms of the sale called for payments by the customer of one-third of
the amount in each month starting on January 15, Year 2.
Required:
Prepare an analysis of this transaction comparing monthly revenues and cash flows.
Solution
Dec. Jan. Feb. Mar.
Year 1 Year 2 Year 2 Year 2
Sales revenue $150,000 $150,000
Cash collections 100,000 $100,000 $100,000
Since half of the goods were delivered in December and the other half in January, the
revenues are split half and half. You may not think that this revenue split is very important,
but because the fiscal year-end is December 31, it means that half the revenue is reported
in fiscal Year 1 and the other half in fiscal Year 2. Improperly reporting revenues distorts
net income and could cause the firms share price to increase or decrease significantly.
Quarterly and annual financial results are very important in accounting because they are
widely reported in the media.
FINANCIAL STATEMENTS
Although companies prepare monthly financial statements and report quarterly results
in the media, we will focus mostly on the annual financial statements. Annual financial
statements are prepared by the companys management from the shareholders point of
L.O. 3
Activity 2.1 compares accounting revenues with cash receipts.
view. Shareholders (both current and prospective), bondholders, and bankers are inter-
ested in the financial statements of a company. Figure 2.2 shows a sample set of finan-
cial statements.
FIGURE 2.2 Sample Set of Financial Statements
The following financial statements report the fiscal 2008 results for Red River Limited, a sports
equipment company with several stores in Western Canada.
Red River Limited
Income Statement
For the year ended December 31, 2008
(in $ thousands)
Sales 500
Less: Cost of goods sold 280
Gross profit 220
Less: Selling expenses 5
Distribution expenses 10
Amortization expenses 35
Administration expenses 70 120
Operating income 100
Add: Gain on sale of land and building 20
Earnings before interest and taxes (EBIT) 120
Less: Interest expense 10
Earnings before income taxes (EBT) 110
Less: Income tax expense (40% 110) 44
Net income 66
Note 1: Earnings per share (EPS) calculation
Net income (from above) 66
Less: Dividends on preferred shares
($0.02 100,000 preferred shares) 2
Net income available to common shareholders 64
Earnings per share (EPS) ($64,000 1 million shares) $0.064
Effect on EPS of a potential share buy-back plan
Assume Red River acquired 100,000 of its own shares in the stock market at the beginning of
2009. This leaves only 900,000 common shares outstanding in 2009. If net income available to
common shareholders for 2009 remained at $64,000, the 2009 EPS would be $64,000 900,000
shares $0.071. This represents a 10.9% [i.e., ($0.071 $0.064) $0.064 100%] increase
in EPS simply because of the reduction in the number of shares outstanding.
Red River Limited
Statement of Retained Earnings
(in $ thousands)
Opening retained earnings, January 1 87
Add: Net income 66
Less: Dividends paid
Preferred shares ($0.02 100,000 shares) 2
Common shares ($0.018 1,000,000) 18 20
Closing retained earnings, December 31 133
Red River Limited
Balance Sheet
As at December 31, 2008
(in $ thousands)
Current assets
Cash 20
Accounts receivable 25
Less: Allowance for doubtful accounts 3 22
Inventory 110
Total current assets 152
Property, plant, and equipment
Land 200
Buildings 300
Less: Accumulated amortization 170 130
Furniture and fixtures 75
Vehicles 30
Net property, plant, and equipment 400
Total assets 552
Current liabilities
Accounts payable 10
Wages payable 4
Income taxes payable 5
Total current liabilities 19
Long-term liabilities
Bonds payable, 10% 100
Total liabilities 119
Shareholders equity
Preferred shares (100,000 shares outstanding) 100
Common shares (1 million shares outstanding) 200
Retained earnings 133
Total shareholders equity 433
Total liabilities and shareholders equity 552
Red River Limited
Cash Flow Statement
(in $ thousands)
Cash flows from operating activities
Net income (from income statement) 66
Add (deduct) non-cash items:
Amortization expense* 35
Gain on sale of land and building* (20)
Decrease in accounts receivable** 5
Increase in inventory** (10)
Increase in current liabilities** 4
Increase in cash from operating activities 80
Cash flows from investing activities
Proceeds from the sale of land and building* 90
Purchase of new land** (40)
Purchase of new furniture and fixtures** (10)
Purchase of new vehicles** (20)
Increase in cash from investing activities 20
Income Statement
Overview
The income statement measures the earnings (profit or loss) of a company during a
given period. The income statement covers an accounting period, not just one point in
time like the balance sheet. Notice from the title of the income statement in Figure 2.2
that it is for the year ended December 31, 2008, meaning that it measures income from
January 1, 2008, to December 31, 2008.
An easy way to remember the income statement is to think about it in terms of a
simple equation. Equation 2.3 expresses the income statement.
Net income Revenues Expenses 2.3
Companies that sell goods must either manufacture or buy them. Either way, when
those goods are sold, the cost of those goods is reported separately from all other
expenses in the cost of goods sold line on the income statement. This allows us to
measure the gross profit, defined as sales less the cost of goods sold. These types of firms
are, at least partly, trading companies. They buy or make something and sell it for a
profit. Gross profit is an important measure because firms must use it to pay all other
expenses, such as selling, distribution, administration, interest, and income tax expens-
es. Service firmssuch as law, accounting, and marketing firmsdo not sell a product
and will not have a cost of goods sold line in the income statement.
Note 1, below the income statement in Figure 2.2, calculates the earnings per share
(EPS) for 2008 and hypothetically for 2009, assuming a share buy-back. As shown, EPS
is obtained by dividing the net income, net of any preferred share dividend, by the
number of shares outstanding. EPS is an important measure of the firms quarterly and
annual results as it is widely reported in the financial media and can have a large impact
on the firms share price. For example if the EPS is below analysts expectations, owners
will often sell the stock en masse, driving down the share price. One way to increase EPS,
all things being equal, is to reduce the number of outstanding shares through a share
buy-back, as shown in Note 1.
Explanation
Notice that the date for the income statement reads for the year ended and, there-
fore, covers the period January 1, 2008, to December 31, 2008.
Sales are revenues from selling sports equipment. The sum for each individual sale
is given by the price of the product sold and the quantity of items sold. Equation 2.4
is the sales equation.
2.4 Sales = Price * Quantity
Cash flows from financing activities
Decrease in long-term bonds payable** (70)
Dividends paid*** (20)
Decrease in cash from investing activities (90)
Total increase in cash (80 20 90) 10
Cash at January 1, 2008 10
Cash at December 31, 2008 (agrees to balance sheet cash) 20
* From income statement
** Compared to last years balance sheet, not provided here
*** From statement of retained earnings
Cost of goods sold is the cost to make or purchase the products that were sold.
Gross profit equals sales less cost of goods sold from inventory.
Selling expenses include sales salaries, commissions, and advertising costs.
Distribution expenses are the cost of shipping products from warehouses to the
stores and to the customers.
Administrative costs include office expenses and salaries.
Gain on sale of land and building is the profit on the sale of a building (including the
land) for $90,000 that was reported on the balance sheet of $70,000. This produced
a $20,000 gain (i.e., $90,000 $70,000). The accounts for land, building, and accu-
mulated amortization on the building were all reduced by this transaction.
Interest expense of $10,000 is calculated as 10% of the $100,000 bond debt
(see balance sheet).
Income tax expense of $44,000 is calculated as 40% of $110,000, the earnings before
income taxes (EBT) (but after interest expenses).
EPS is net income available to common shareholders divided by number of shares
outstanding.
Statement of Retained Earnings
Overview
This statement of retained earnings measures the changes in retained earnings from
one year to the next. It can be expressed as Equation 2.5.
Closing retained earnings Opening retained earnings
Net income Dividends 2.5
The term retained earnings stems from the fact that net income less dividends is
the net amount of earnings that are retained within the business. The retained earn-
ings account is one of the components of shareholders equity because these profits
belong to the common shareholders. Companies generally consider the amount in
retained earnings as the maximum amount that could be declared for dividends.
However, do not think of retained earnings as cash: they only represent the sharehold-
ers claim on company assets. Sometimes the board of directors will limit the use of
or set aside a portion of retained earnings for capital project allocations, thereby fur-
ther limiting the size of potential future dividends. This is not the same as setting aside
cash. It merely limits the size of future dividends and announces managements future
intentions, usually disclosed in a note accompanying the financial statements. Funds
for capital projects, including limiting dividend payouts in order to retain more cash
for expansion plans, is considered in Chapters 8 and 10.
Explanation
Notice that the date for the statement of retained earnings also reads for the year
ended and also covers the period January 1, 2008, to December 31, 2008.
The opening retained earnings balance is obtained from last years balance sheet.
Net income is the amount from the income statement.
Dividends on preferred shares and common shares are declared by the board of
directors. The preferred share dividend is fixed at $0.02 per preferred share. The
common share dividend for 2008 was $0.018 per common share and, unlike the
preferred dividend, will likely increase as future profits increase.
Closing retained earnings agrees to this years retained earnings in the shareholders
equity section of the balance sheet.
Balance Sheet
Overview
The balance sheet shows the financial position of the company at a point in time. The
balance sheet is different from the two previous statements in that it is only valid at a
single point in time. In Figure 2.2, the balance sheet shows the financial position of the
company at the close of business on December 31, 2008. The next day, in the case of a
merger between two companies, for example, the balance sheet might look completely
different. So, the balance sheet is more like a snapshot at one point in time rather than
a movie covering the entire year, like the income statement.
The balance sheet shows what the company owns (the assets), what the company owes
(the liabilities), and what is left over for the shareholders (shareholders equity). However,
the balance sheet does not normally reflect what the company is worth. That is a far more
complex question that will be addressed later in the text. The non-financial assets are
reported at cost or amortized cost. For example, land that cost $10 million 20 years ago may
now be worth $100 million, but that increased value is not reported on the balance sheet.
The balance sheet generally uses the cost principle, in which assets are reported at cost less
accumulated amortization. Similarly a $20 million building might be reported on the
balance sheet 15 years later at $5 million (i.e., $20 million cost $15 million accumulated
amortization), even though it would have a fair value of $150 million if sold today.
However, as noted below in the discussion on recent accounting developments in Canada,
the strict adherence to the cost principle will soon be relaxed. This will give companies the
choice of reporting these assets at net fair value or amortized cost.
Explanation
Notice the change in the date reference here. The balance sheet in Figure 2.2 reads
as at December 31, 2008. This means it is valid only on one day.
Current assets are assets that last for less than one year. These include cash or items
likely to be turned into cash or used up within a year.
Cash includes petty cash on hand at the company offices to pay incidental expenses
plus cash in the companys bank accounts.
Accounts receivable are amounts related to credit sales that will hopefully soon be
collected, usually within 30 to 60 days.
Allowance for doubtful accounts is a deduction from accounts receivable in recog-
nition that some customers will refuse to pay and others may go bankrupt and not
pay their bills.
Inventory is the cost of goods available for sale that have not yet been sold.
Property, plant, and equipment are assets used in the operation of the business.
They are expected to last longer than one year.
Land is the cost of the land owned by the company, including land on which the
companys buildings are located. Usually when the company buys a building, it
agrees to one price that includes both the building and the land. So the price paid
must be analyzed by the company and split into a land cost and a building cost.
The reason for splitting the cost this way is that land is considered to last forever
and therefore does not need to be amortized.
Buildings represent the cost allocated to constructing or buying the buildings.
Buildings generate amortization expense on the income statement every year until
they are fully amortized.
Accumulated amortizationBuilding is the total amount of amortization expense taken
by the company in all the years since it has owned the building. In Red Rivers case, the
buildings are over half amortized (i.e., $170,000 $300,000 100% 56.6%).
Furniture and fixtures is the cost of the office and store furniture, and store shelving.
Accumulated amortizationFurniture and fixtures shows that Red Rivers furniture
and fixtures are one-third amortized (i.e., $25,000 $75,000).
The vehicles account is the cost of company cars and trucks.
Accumulated amortizationVehicles indicates that Red Rivers vehicles are also
one-third amortized (i.e., $10,000 $30,000).
Net property, plant, and equipment includes the total of long-term assets for Red
River, less accumulated amortization. Other companies may also have intangible
assets, such as patents.
Total assets are the total unamortized cost of all the assets owned by the company.
Current liabilities are amounts the company must repay within one year.
Accounts payable is the amount owing for goods the company has purchased,
including inventory and regular credit items for the office and store.
Wages payable is the amount owing to the companys employees for work completed.
The fact that the company owes wages to its employees does not signify that it is in
financial trouble and cannot pay its workers. It simply means that the balance sheet
was prepared between payday dates, so there are wage liabilities in existence until
payday comes around. The matching principle, together with the accrual accounting
method, dictates that these wage expenses and wages owing be recognized in the
income statement and balance sheet respectively.
Income taxes payable is the amount owing to the government for income taxes.
Income taxes payable is always a current liability because the government will not
wait very long to get its money.
Total current liabilities are the total amount to be repaid in the next year.
Long-term liabilities are amounts to be repaid more than one year into the future.
Bonds payable, 10%, is the amount of long-term bonds issued by the company at
10% interest.
Total liabilities are the sum of current and long-term liabilities owed by the company.
Shareholders equity includes common shares, preferred shares, and retained
earnings.
Preferred shares, as noted earlier, have a stated dividend amount, which is $0.02 per
preferred share for Red River.
Common shares, which currently receive a dividend of $0.018 per share, as noted
earlier, can expect to see the dividend grow as the firms net income increases.
Retained earnings are the sum of all net income less dividends over all the years the
company has been in business.
Total shareholders equity is the residual amount left over for the shareholders,
after subtracting the debt from the assets owned. Where preferred shares exist, the
preferred share amount is also deducted from total assets to arrive at the total
shareholders equity available to common shareholders.
Total liabilities and shareholders equity equals total assets.
Cash Flow Statement
Overview
The cash flow statement shows the sources and uses of cash for the company through-
out the year. It shows investors and bankers where the company got its money during
the year and what was done with it. Only transactions involving cash appear in the
income statement. For example, assume a company sells land for a $5,000 down pay-
ment and holds a $95,000 mortgage for the remainder of the selling price. Only $5,000
will appear in the cash flow statement, because the mortgage does not involve cash.
Template for
Cash Flow
The cash flow statement is very important because many of the decision making con-
cepts in finance deal with cash flows. The cash flow statement is divided into three sections:
1. Cash flows from operating activities
2. Cash flows from investing activities
3. Cash flows from financing activities.
Cash flows from operating activities Cash from operating activities measures the
amount of cash generated by the main business activities of the company, such as cash
from customers and cash paid for purchases of inventory. Net income is often used as the
starting point for determining the cash flows from operations. However, cash from oper-
ations is not the same as net income because the income statement uses many non-cash
concepts, such as the accrual concept. The use of accrual accounting requires several
adjustments in order to restate net income to a cash basis in the cash flow statement.
Prominent among these adjustments is the need to add back amortization expense to net
income because it is always a non-cash expense.
Another common adjustment is the need to deduct any gains or add back losses on
the sale of capital assets. However, cash received from these transactions is reported in the
next section, cash flows from investing activities.
Cash flows from investing activities This section of the cash flow statement indicates
how much cash was spent during the past year on acquiring new capital assets, such as
land, buildings, and equipment. It also shows how much cash was received from sales of
old capital assets. Companies must continually make new investments in long-term
capital assets in order to remain productive; cash from investing activities will typically
be a negative figure, meaning net new assets were acquired.
Cash flows from financing activities This section of the cash flow statement shows
all cash inflows from issuing new shares and new long-term debt as well as all cash
outflows from paying down long-term debt, buying back shares from investors, and
paying dividends.
Explanation
Cash flows from operating activities
Net income is the starting point in the measurement of cash flows from operating
activities. Then a series of non-cash adjustments are made to convert net income
to a cash flow:
Amortization expense from the income statement is added back to net income
since it is a non-cash expense on the income statement. For cash flow purposes,
amortization expense is cancelled out (negative in the income statements net
income and positive in the cash flow statement adjustment).
The gain on the sale of the land and building is similarly cancelled out (positive
in the income statement and negative in the cash flow statement adjustment)
because the entire cash sale price of $90,000, which includes the gain amount,
is included as proceeds from the sale in the cash flows from investing activities.
The gain would be double-counted if it were not cancelled out.
The decrease in accounts receivable during the year represents a cash inflow
() since more receivables were collected.
The increase in inventory during the year represents a cash outflow () to pay
for more inventory.
The increase in current liabilities represents a cash inflow () since cash was
saved by not paying for these debts.
SELF-ASSESSMENT QUESTI ON 2. 1
The Prince George Airport Authority has the following unsorted trial balance for December 31, 2008. All accounts
are shown and all have normal account balances.
Accounts payable $ 47,000
Land 100,000
Cash 25,000
Salaries expenses 300,000
Hangars 275,000
Bonds payable, due 2020 200,000
Airplanes 450,000
Accumulated amortizationHangars 100,000
Common shares 200,000
Accounts receivable 70,000
Revenues 1,200,000
Accumulated amortizationAirplanes 100,000
Gas expenses 670,000
Retained earnings, January 1, 2008 203,000
Dividends 100,000
Amortization expense 60,000
Required:
(a) Prepare an income statement for the year ended December 31, 2008.
(b) Prepare a statement of retained earnings for the year ended December 31, 2008.
(c) Prepare a balance sheet as at December 31, 2008.
Cash flows from investing activities
As noted above, the entire sales price for the land and building is shown as an
increase () in cash from investing activities.
In this section of the cash flow statement, we learn that Red River acquired new land
for $40,000, new furniture and fixtures for $10,000, and new vehicles for $20,000.
Cash flows from financing activities
Red River spent $70,000 to retire a portion of its long-term bonds and another
$20,000 to pay for the dividends.
Conclusion
Overall, cash inflows from operations generated $80,000, cash inflows from invest-
ing activities resulted in another $20,000, and $90,000 was spent on paying off some
long-term bonds and paying the dividend. The net result was a $10,000 increase in
cash (i.e., $80,000 $20,000 $90,000), which was added to the $10,000 cash
balance at the beginning of the year to arrive at the $20,000 cash amount appearing
on the year-end balance sheet.
Overall, Red River generated a significant positive cash flow in 2008 and used it to
pay down its long-term debt. Red River can expect to be debt-free within two years
if this trend continues, since its total long-term debt is only $100,000.
Cash Flow in Finance
Cash flow for finance looks to the future as opposed to the formal cash flow statement
in accounting, which measures changes to cash in the past year. Expected future cash
flows arising from decisions to buy new property and equipment are an important
aspect of finance and will be covered in later chapters. Example 2.2 shows how a cash
budget focusing on future cash receipts and cash expenditures is developed.
Example 2.2
Flex Systems Inc. starts the year on January 1, 2008, with $35,000 cash in the
bank. The balances in accounts receivable at month-end for November and
December 2007 were $15,000 and $20,000 respectively. All sales are credit sales.
New additions to accounts receivable from credit sales for January, February, and
March 2008 were $15,000, $20,000, and $35,000 respectively. It has been the tra-
ditional pattern that 70% of receivables are collected in the month following the
sale and the remainder is collected in the second month following the sale.
Monthly cash expenses are $25,000.
Required:
Prepare a cash budget for the first three months of 2008 showing opening cash,
cash collections, cash expenditures, and closing balance.
Solution
Nov. Dec. Jan. Feb. Mar.
2007 2007 2008 2008 2008
Receivables $15,000 $20,000 $15,000 $20,000 $35,000
Opening cash $35,000 $28,500 $20,000
Collections
70% of 1 month ago 14,000 10,500 14,000
30% of 2 months ago 4,500 6,000 4,500
Total collections 18,500 16,500 18,500
Payments 25,000 25,000 25,000
Ending cash $35,000 $28,500 $20,000 $13,500
The January 2008 cash collections consist of 70% of the December 2007
accounts receivable (i.e., 70% $20,000 $14,000) plus 30% of the November
2007 receivables (i.e., 30% $15,000 $4,500), for a total cash inflow of $18,500.
Analyzing the December 2007 accounts receivable balance of $20,000, we see that
$14,000 (i.e., 70%) is collected in January and $6,000 (i.e., 30%) is collected in
February.
This example shows the impact of accrual accounting on the calculation of cash
flows. Sales made on credit appear in the income statement in one month but they do
not affect cash until the following two months, when the receivables are collected. We
will see more on cash flows in later chapters.
Recent Accounting Developments in Canada
Early in 2006, the Accounting Standards Board announced that, by 2011, Canada will
no longer have its own separate generally accepted accounting principles (GAAP).
Instead, companies will be allowed to choose between preparing their financial state-
ments according to International Financial Reporting Standards (IFRS), as used by
much of the world, or according to U.S. GAAP. Either of these standards will satisfy
Canadian requirements.
This harmonization of accounting standards, the aim of which is one set of common
worldwide accounting rules, has been underway for many years, and great progress has
been made recently. Harmonized accounting standards may make it easier for investors
and bankers to compare financial results and make investment decisions. Harmonization
will also save the companies time and money because they will have to prepare only one
set of financial statements. Consider the current situation of a large Canadian company
whose shares are listed on the Toronto Stock Exchange, the New York Stock Exchange, and
the London Stock Exchange. This company now has to prepare three sets of financial
statements; in 2011, it may need to prepare only one set of financial statements.
A significant accounting difference under IFRS is that companies will be able to
choose to report inventory and capital assets (such as land and buildings) at fair market
value. For example, a Canadian bank with an office tower in downtown Toronto, built in
the 1970s for $30 million, will be able to report it on the balance sheet at its appraised fair
value of $550 million under the IFRS standards. All of a sudden, the banks assets and
shareholders equity will dramatically increase. However, companies will have to think
carefully about this choice because the consequence of reporting an inflated fair value for
the building will be inflated future amortization expenses, as the higher building amount
will have to be amortized. This will depress future earnings for years to come.
On the other hand, a shift to U.S. GAAP will not be too onerous, as Canadian and
U.S. accounting standards are already quite similar. Exceptions include research and
development costs, and some other specialized areas.
AMORTIZATION AND CAPITAL COST ALLOWANCE
Amortization is an accounting term referring to the apportionment of the cost of a long-
term capital asset to the income statement as an expense. We saw an example earlier in
which a $20 million building, with an estimated useful economic life of 20 years and no
residual value, caused $100,000 of amortization expense to be reported in the income
statement every year for 20 years.
Considerable judgment is involved in using estimated values, such as useful eco-
nomic life and residual value of an asset. If another company uses a useful economic
life of 10 years for a similar building, its amortization expense is $200,000 per year,
twice as high as its competitors.
The taxation authorities wanted to remove this judgment factor in determining cor-
porate income taxes, so they devised the capital cost allowance (CCA) method. CCA is
the tax returns equivalent to amortization expense. CCA is optional and probably is not
taken in a year in which the company has a taxable loss, but amortization expense must
be reported every year. Another major difference is that the Income Tax Act specifies the
L.O. 4
Template for CCA
maximum CCA rate that can be used to calculate the CCA deduction, thereby removing
the judgment factor involved in determining an assets economic useful life.
CCA is calculated on a pooled asset basis. This also differs from amortization,
which is calculated on an individual asset basis. The Income Tax Act specifies various
asset classes and their CCA rates. Most buildings fit into class 1 with a 4% CCA rate,
trucks and cars are class 10 with a 30% CCA rate, and manufacturing equipment is
class 43, also with a 30% CCA rate.
Table 2.2 presents a 25-year comparison between the amount of CCA taken in the
tax return and amortization expense taken in the income statement. Capital cost
allowance works on a declining balance basis, with the half-year rule in effect for the year
in which the asset is acquired. Suppose a new company has one building, acquired
this year for $2,000,000. The maximum amount of CCA that could be claimed for the
building in the first year is
1
2
4% $2,000,000 $40,000. Now the balance in the
building account for tax purposes has declined to $2,000,000 $40,000 $1,960,000.
The $1,960,000 remaining balance is the amount that is undepreciated for tax purposes
and is called the undepreciated capital cost (UCC) of the building. For the second year,
the maximum CCA deduction is 4% UCC balance 4% $1,960,000 $78,400.
One difference is that the CCA rate is 4%, while the amortization rate is 5%.
Another big difference in this example is that amortization expense is constant over 20
years. At that point, amortization expense ends because the asset is fully amortized. On
the other hand, CCA is calculated on a declining balance method. The CCA amount
TABLE 2.2 25-Year Comparison Between CCA in Tax Return and Amortization
Expense in Income Statement
Amortization Expense
Opening CCA at Closing (Straight-Line Net
Year UCC 4% UCC Over 20 Years) Book Value
1 $2,000,000 $40,000 $1,960,000 $100,000 $1,900,000
2 1,960,000 78,400 1,881,600 100,000 1,800,000
3 1,881,600 75,264 1,806,336 100,000 1,700,000
4 1,806,336 72,253 1,734,083 100,000 1,600,000
5 1,734,083 69,363 1,664,719 100,000 1,500,000
6 1,664,719 66,589 1,598,130 100,000 1,400,000
7 1,598,130 63,925 1,534,205 100,000 1,300,000
8 1,534,205 61,368 1,472,837 100,000 1,200,000
9 1,472,837 58,913 1,413,924 100,000 1,100,000
10 1,413,924 56,557 1,357,367 100,000 1,000,000
11 1,357,367 54,295 1,303,072 100,000 900,000
12 1,303,072 52,123 1,250,949 100,000 800,000
13 1,250,949 50,038 1,200,911 100,000 700,000
14 1,200,911 48,036 1,152,875 100,000 600,000
15 1,152,875 46,115 1,106,760 100,000 500,000
16 1,106,760 44,270 1,062,489 100,000 400,000
17 1,062,489 42,500 1,019,990 100,000 300,000
18 1,019,990 40,800 979,190 100,000 200,000
19 979,190 39,168 940,023 100,000 100,000
20 940,023 37,601 902,422 100,000
21 902,422 36,097 866,325
22 866,325 34,653 831,672
23 831,672 33,267 798,405
24 798,405 31,936 766,469
25 766,469 30,659 735,810
gradually declines each year (except for the increase in the second year caused by the
application of the half-year rule in the first year), because the same CCA rate is applied
to a declining UCC balance. Notice that the CCA amounts continue for Years 21 to 25,
while the amortization is zero for those years.
Unless explicitly stated to the contrary, most problems, cases, examples, and situa-
tions described in this text assume that the amount of CCA taken in a year is the same
as the amortization reported. The reason for making this simplifying assumption is to
clearly focus on the particular issue we are studying, without complicating it too much
with extra tax issues.
Disposal of the Only Asset in a CCA Class
Theoretically, the CCA will go on forever, as long as there are assets remaining in the
CCA class, because the UCC balance never quite gets to zero. However, when the last
asset in a CCA class is sold, there are usually income tax implications because the CCA
class has been terminated. Depending on the selling price of the asset, there are four
possible income tax scenarios.
Case 1: No further income tax impact Assume the building in Table 2.2 is sold at the
beginning of Year 26 for $735,810. Since this amount exactly matches the opening
UCC balance, the proceeds from the sale reduce UCC to zero. No further CCA can be
claimed and there are no further tax implications.
` Opening Closing
Year UCC CCA UCC Comments
25 $766,469 $30,659 $ 735,810
26 (735,810) Proceeds from sale
26 nil Adjusted opening balance
26 nil nil nil
Opening Closing
25 $766,469 $30,659 $ 735,810
26 335,810 Adjusted opening balance
26 (335,810) Terminal loss
26 nil nil nil
Case 2: Terminal loss reduces income taxes Assume the building in Table 2.2 is sold
at the beginning of Year 26 for $400,000. Now there is a balance of $335,810 when the
proceeds are subtracted from the opening UCC balance. This is a terminal loss because
there are no more assets remaining in this class and there is a positive UCC balance in
the class. Terminal losses are fully deductible on the tax return and therefore reduce
income tax payable. Terminal losses also reduce the UCC balance to zero.
The tax saving on this terminal loss is the tax rate multiplied by the terminal loss,
as shown in Equation 2.6.
Tax saving Tax rate Terminal loss 2.6
Assuming a tax rate of 40%, the tax saving for this terminal loss would be $134,324
(i.e., 40% $335,810).
Case 3: CCA recapture increases income taxes Assume the building in Table 2.2 is
sold at the beginning of Year 26 for $1,500,000. Now there is a negative balance of
$764,190, when the proceeds are subtracted from the opening UCC balance. The nega-
tive balance, representing a credit balance in UCC, is called recaptured CCA.
The CCA recapture amount is added to income in the tax return and results in
higher income tax for the company. The rationale for having to pay more income tax is
that the company must not have paid enough tax in the past, due to its CCA deductions
being too high in past tax returns (although within legal limits). The evidence for this
conclusion is that the buildings value has not really depreciated down to $735,810, since
it was sold for such a high price.
Proceeds from sale $2,500,000
Original cost 2,000,000
Capital gain $ 500,000
Taxable portion 50%
Taxable capital gain $ 250,000
The additional tax would amount to $305,676 (i.e., 40% $764,190), using
Equation 2.6, which also applies in this case.
Case 4: Taxable capital gain plus CCA recapture Assume the building in Table 2.2 is sold
at the beginning of Year 26 for $2,500,000. There are now two components generating
additional taxesthe capital gain and the CCA recapture.
The proceeds from the sale exceed the original cost of the building. This generates a
capital gain of $2.5 million $2 million $500,000. Capital gains are valued highly by
both individuals and corporations because only half of the capital gain is subject to
income tax. Therefore, the taxable capital gain in this case is 50% $500,000 $250,000,
as shown in the following calculation.
Additional tax on the taxable capital gain amounts to $100,000 (i.e., 40% $250,000).
In addition there is the CCA recapture amount of $2,000,000 $735,810
$1,264,190. This is added to taxable income. The maximum amount of proceeds that
can be deducted from the opening UCC balance to determine the amount of CCA
recaptured is the original cost of the asset.
Opening Closing
25 $766,469 $30,659 $ 735,810
26 (1,500,000) Proceeds from sale
26 (764,190) Adjusted opening balance
26 764,190 CCA recapture
26 nil nil nil
Opening Closing
25 $766,469 $30,659 $ 735,810
26 (2,000,000) Proceeds from sale are limited
to the original cost for UCC
calculations
26 (1,264,190) Adjusted opening balance
26 1,264,190 CCA recapture
26 nil nil nil
ACTIVITY 2.2
Assume the data in Table 2.2 represented two different buildings instead of one large building.
Consider each of the following situations independently.
Required:
(a) What is the tax impact of selling one building at the beginning of Year 26 for $300,000?
(b) What is the tax impact of demolishing one of the two buildings due to faulty construction?
(c) What is the tax impact of selling one of the two buildings for $900,000?
Solution
Since there are two buildings in this tax class, these transactions generally do not result
in an empty UCC class.
(a) The proceeds from the sale reduce the UCC in this asset class. The same 4% CCA
rate is now applied on the adjusted opening balance. Thus the result of selling an
asset when other assets remain in the asset class is to reduce the undepreciated
capital cost (UCC) of the asset class and reduce future capital cost allowance (CCA).
This results in an increase in taxes paid.
CCA for Year 26 is $17,432 after the sale of one building, whereas CCA would have
been 4% $735,810 $29,432 if the building had not been sold.
Additional tax on the recaptured CCA amounts to $505,676 (i.e., 40% $1,264,190).
If other assets remain in the same tax class, then 50% of any capital gain is added to
taxable income in the usual manner, and the rest of the proceeds are used to reduce the
UCC of the class, so that future CCA is reduced.
Opening Closing
25 $766,469 $30,659 $ 735,810
26 435,810 435,810 Adjusted opening balance
26 435,810 17,432 418,378 CCA is reduced
Opening Closing
25 $766,469 $30,659 $ 735,810
26 900,000 Proceeds from sale
26 (164,190) Adjusted opening balance
164,190 CCA recaptured
26 nil Adjusted balance
26 nil nil nil
INCOME TAXES
Corporate Taxes
Income taxes are an unusual type of expense because they are based on net income,
which is determined by subtracting expenses from revenues. Net income serves as
the starting point in the determination of income taxes payable and then income tax
expense. Net income is adjusted to arrive at taxable income according to the legal
requirements of the Income Tax Act. The income taxes payable are determined
using Equation 2.7.
Taxes payable Corporate tax rate Taxable income 2.7
The federal corporate tax rates in Canada for 2008 start out at 38% and through
a series of reductions are reduced to 20.5%, further reducing to 20% for 2009.
Provincial and territorial corporate income taxes add an extra 10% to 16% for active
business income and investment income, depending on the province. Some
jurisdictions further reduce corporate income tax rates on manufacturing and
processing income in an effort to attract more industry. For example, the combined
L.O. 5
(b) Since no proceeds were involved in demolishing the building, the asset class contin-
ues with the same opening UCC balance for Year 26 as at the end of Year 25. In other
words, CCA for Year 26 amounts to 4% $735,810 $29,432 and continues just
as if the building had never been demolished.
(c) Selling one building for $900,000 results in additional taxable income equal to the
recaptured CCA of $164,190. This will increase income tax payable in Year 26 by
$65,676 (i.e., 40% $164,190). Further CCA will not be available since the UCC
balance is zero for this class.
Opening Closing
25 $766,469 $30,659 $735,810 No adjustment needed
26 735,810 29,432 706,378 CCA continues
Template for Tax
federal and provincial tax rate for Ontario corporations for 2008 is 20.5% 14%
34.5%, with the rate dropping to 32.5% for manufacturing and processing income.
Taxable Income
We have already seen that amortization expense is one of the major adjustments needed
to transform accounting net income into taxable income on the companys tax return.
Amortization expense is not permitted in the Income Tax Act. However, as we have seen
earlier, a similar deductible expense, called capital cost allowance, is permitted.
Other adjustments often include moving from an accrual basis in accounting to a cash
basis in the tax return. The government does not want a company to lower its tax bill by
making high estimates for its expenses. These estimated expenses, which are required in
accounting, are often not deductible in the tax return. Instead, only the cash payments are
tax-deductible. Two examples of this are estimated warranty expenses and pension
expense. Only actual cash warranty expenses paid, not estimates, are allowable deductions
in the tax return. Similarly, the actual cash pension funding paid to the companys pension
fund trustee, not the unfunded portion of the expense, is tax-deductible.
Another adjustment for corporations is that dividends received from other
Canadian corporations are not taxable. Since corporations pay dividends out of after-
tax income, taxes have already been paid for these dividends. So, they are not taxed
again in the hands of another corporation.
As noted previously, capital gains are a valuable source of income because only half
of the capital gain is included in taxable income.
Activity 2.3 focusses on determining taxable income and taxes payable.
ACTIVITY 2.3
The Montreal Furniture Company Ltd. earned an accounting income before income taxes of
$550,000 in 2008. Amortization expense was $100,000. The capital cost allowance permit-
ted in 2008 is $150,000. This is the only temporary difference between accounting net income
and taxable income. The combined federal and provincial tax rate is 40%.
Required:
(a) Calculate taxable income for Montreal Furniture for 2008.
(b) Calculate income taxes payable for Montreal Furniture for 2008.
Solution
(a) Accounting income before income taxes $550,000
Adjustments to determine taxable income:
Add back: Non-deductible amortization expense 100,000
Deduct: CCA for 2008 (150,000)
Taxable income for 2008 $500,000
(b) Taxable income for 2008 (from part (a)) $500,000
Tax rate for 2008 40%
Taxes payable for 2008 (40% $500,000) $200,000
Who Said There Is No Such Thing as Negative Taxes?
Nortel Networks is a large Brampton, Ontariobased global communications equipment maker. The following are
extracts from its recent financial statements:
REAL
WORLD
2.1
(U.S. $ millions)
2005 2004
I ncome statement
Loss before income taxes (2,586) (240)
Income tax benefit 56 230
After tax loss (2,530) (210)
Balance sheet
Assets
Future income taxesnet 377 255
Nortel is showing that its losses in 2005 and 2004 have been reduced by US$56 million and US$30 million,
respectively, due to the negative income tax expense effect, which Nortel calls an income tax benefit. The balance
sheet shows a huge future tax asset in both years for the benefit of being able to apply these losses carried forward
to reduce future income tax payable.
Source: 2005 Nortel Networks annual report.
Tax Loss Carry-Backs and Carry-Forwards
Since net income and taxable income can be negative in a year with a loss, income tax
payable and income tax expense can in fact also be negative. Firms can carry a taxable
loss back to the previous three years and obtain a refund of the taxes paid in these
years. If the loss is so large that it cannot all be used up against the previous three years
taxable income, the unused loss can be carried forward and used in any of the next
20 years to reduce taxable income. For accounting purposes, the future tax rate multi-
plied by the amount of the loss carry-forward is reported on the balance sheet as a
future income tax asset. A future income tax asset is a valid asset because real cash
savings are created by deducting the current years loss carry-forward from future
income. The offset to the future income tax asset account (dr) is negative income tax
expense (cr). Accounting issues in the preparation of income taxes are often complex
and confusing; we are only touching on them in this text. Students specializing in
finance or accounting will usually take an entire course dedicated to this subject.
Real World 2.1 shows how one company was able to reduce its loss before income
taxes by applying tax loss carry-back and carry-forwards.
Individual Taxes
Canada has a progressive income tax system in place for individuals. That is, the higher
your income, the higher your tax rate. Table 2.3 shows the 2007 federal income tax
brackets for various amounts of taxable income.
In addition to the federal rates, provincial and territorial income tax rates range
from 5.7% to 24%, depending on the tax bracket and the jurisdiction.
The higher tax rate percentage only applies to the income amount starting at the tax
rates lower threshold level. Income up to this threshold point is taxed at the previous
On the first $37,178 15.5% $37,178 $ 5,762.59
On the next $70,000 $37,178 $32,822 22.0% $32,822 7,220.84
Total taxes payable $12,983.43
tax brackets rate. For example, assume Jackie Bishop earned a gross income of $80,000,
which reduced to a taxable income of $70,000 in 2007 after deductions. $70,000 falls
into the second tax bracket, with a 22.0% tax rate in Table 2.3. However, the higher tax
rate of 22.0% only applies to the income amount from $37,179 up to $70,000. The first
$37,178 of income continues to be taxed at the lower 15.5% rate. The calculation for the
taxes payable is:
TABLE 2.3 2007 Federal Income Tax Rates for Individuals
Tax Rate Taxable Income
15.5% $0$37,178
22.0% $37,179$74,357
26.0% $74,358$120,887
29.0% Over $120,888
The average tax rate is given by Equation 2.8:
2.8
Jackie Bishops average tax rate is $12,983.43 $80,000 100%16.2%.
The marginal tax rate is given by Equation 2.9:
2.9
Jackie Bishops marginal tax rate is 22.0%, considerably higher than her average
tax rate. The marginal tax rate should always be used for making decisions. For
instance, assume that Jackie is offered the chance to work overtime. If accepted, it
would boost her income to $95,000 and her taxable income to $85,000. Notice that this
amount puts her into the 26% federal income tax bracket for most of the overtime.
Furthermore, assume this puts her into a 17% income tax bracket in her province. Her
combined federal and provincial marginal tax bracket is 26% 17% 43%. Since she
only gets to keep 57% (i.e., 100% 43%) of most of the overtime dollars earned, she
might decide to refuse the overtime work.
Dividends
From an individual shareholders point of view, dividends present a double taxation
problem because dividends are paid out of retained earnings, which is the accumulated
net income less dividends. However, the corporation has already paid taxes on its net
income, adjusted to taxable income in the tax return. So the dividend received by the
individual is actually paid out of income less taxes. The individual shareholder must
again pay taxes on dividends received. To grant some relief from this double taxation
motif, dividends are grossed up and a dividend tax credit is allowed in the individuals
tax return. As a result, dividends are taxed more lightly than ordinary income in
the hands of individuals. These are complicated manoeuvres that are designed to try to
overcome double taxation problems with dividends.
Marginal tax rate = Tax rate on the last dollar of income
Average tax rate =
Total taxes payable
Gross income
Significant Accounting Terms
Asset: something the company owns.
Liability: amount the company owes.
Shareholders equity: residual amount belong-
ing to the shareholders.
Working capital: current assets less current
liabilities.
Revenues: sales earned when the product is
delivered to the customer or the job is completed.
Expenses: costs incurred to generate the sales.
Expenses are matched to revenues.
Dividends: distribution of profits to the share-
holders.
Accrual Accounting, Cash Flows, and the
Matching Principle
Accrual accounting
Reporting sales when made, not when the
cash is collected.
Reporting expenses when incurred, not when
paid.
Cash flows: the measurement and timing of
cash inflows and cash outflows in a business.
Matching principle: expenses in a period
are matched to the same period in which the
related revenues were generated.
Financial Statements
Income statement: measures the earnings of a
company during a period.
Statement of retained earnings: measures the
changes in retained earnings for the period.
Balance sheet: presents the financial position of
the company at a certain date by showing its
assets, liabilities, and shareholders equity.
Cash flow statement: shows where cash was
obtained and where it was spent during the
period.
Amortization and Capital Cost
Allowance
Amortization: the apportionment of part of the
cost of a capital asset each year to the income
statement as an expense.
Capital cost allowance: the tax returns equiva-
lent to amortization expense.
CCA rates are specified in the Income Tax Act
for various asset classes.
CCA presents additional tax complications at the
end of the useful life of an asset and especially
when the entire asset class is terminated.
Income Taxes
Taxable income is determined by starting with
net income and making adjustments to arrive at
taxable income.
Taxes payable equal the sum of, for each tax
bracket, the applicable tax rate multiplied by the
applicable slice of taxable income.
Asset
Liability
Shareholders equity
Working capital
Revenues
Balance sheet
Cash flow statement
Amortization
Capital cost allowance
(CCA)
K E Y T E R M S
S U M M A R Y
Expenses
Dividends
Matching principle
Income statement
Statement of retained earnings
2.1 Assets = Liabilities + Shareholders equity
2.2 Working capital = Current assets Current liabilities
2.3 Net income = Revenues Expenses
L I S T O F E Q U A T I O N S
P R O B L E M S A N D C A S E S
2.1 Your company is reviewing the following accounts:
Bonds payable Inventory
Dividends Accounts payable
Cash Accounts receivable
Accumulated amortizationCars Income taxes payable
Common shares Net income
Required:
Group the preceding accounts as asset, liability, or shareholders equity accounts.
2.2 The Jamery Goods Company has the following account balances:
Bonds payable, due 2016, $100,000
Inventory 30,000
Dividends 10,000
Accounts payable 20,000
Cash 200,000
Accounts receivable 60,000
Accumulated amortizationCars 30,000
Income taxes payable 15,000
Common shares 120,000
Net income 50,000
Cars 75,000
Opening retained earnings 40,000
Required:
Prepare a statement of retained earnings using whichever of the preceding accounts you need from the
December 31, 2008, books of the Jamery Goods Company.
R E V I E W Q U E S T I O N S
Answers to the Review Questions can be found on
the Companion Website that accompanies this text
at www.pearsoned.ca/atrill.
2.1 Why is the shareholders equity section of the
balance sheet sometimes called the residual?
2.2 What makes the balance sheet balance?
2.3 Does the matching principle mean that expenses
have to equal revenues? Explain.
2.4 Explain why net income is not the same as
taxable income.
2.5 Executives would prefer to show lower earn-
ings per share because the companys tax bill
will be reduced. Discuss.
2.4 Sales = Price Quantity
2.5 Closing retained earnings = Opening retained earnings + Net income Dividends
2.6 Tax saving = Tax rate Terminal loss
2.7 Taxes payable = Corporate tax rate Taxable income
2.8
2.9 Marginal tax rate = Tax rate on the last dollar of income
Average tax rate =
Total taxes payable
Gross income
Required:
2.3 Using the data from Problem and Case 2.2, prepare a balance sheet as at December 31, 2008, for the
Jamery Goods Company.
2.4 Rain Coast Adventures Ltd. acquired a new ski lift on January 1, Year 1, for $1,500,000. It has an estimated
useful economic life of 10 years with no residual value. The ski lift has a CCA rate of 20%.
Required:
Compare accounting straight-line amortization and net book value and tax return CCA and UCC for the 10-year
life of the ski lift.
2.5 Tims Bits and Drills Inc. has had the following results over the past five fiscal years.
2004 2005 2006 2007 2008
Net income $100,000 $150,000 $200,000 $250,000 $300,000
Taxable income $ 52,000 $ 75,000 $ 98,000 $121,000 $144,000
Tax rate 30% 34% 45% 48% 28%
Required:
(a) Calculate income taxes payable for each year.
(b) Describe two things that might cause the difference between net income and taxable income.
2.6 Maritime Breweries Limited reported the following results for 2008.
Earnings before income taxes $5,025,000
Amortization expense $1,250,000
UCCBuildings, Jan. 1, 2008 $3,000,000
CCA rateBuildings 4%
UCCMachines, Jan. 1, 2008 $5,600,000
CCA rateMachines 20%
UCCVehicles, Jan. 1, 2008 $ 800,000
CCA rateVehicles 30%
Required:
(a) Calculate taxable income for 2008.
(b) Calculate taxes payable for 2008, assuming a corporate tax rate of 35%.
2.7 The president of Fallen Down Gold Mines stated, The company does not have sufficient cash to pay
its $2 million dividend in 2008. During his speech, he said that cash inflows from operations are
expected to be $2,500,000, cash outflows from investing are expected to be $(1,400,000) and cash
inflows from financing are expected to be $500,000.
Required:
(a) How might you determine if the presidents statement is accurate?
(b) What is the minimum amount of the opening cash balance required in order to pay the $2 million
dividend and remain with a cash balance of $350,000 at the end of this year?

Accounting - The Language of Business: Learning Outcomes

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Accounting - The Language of Business: Learning Outcomes

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INTRODUCTION

In this chapter we review key accounting topics that you

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