Chapter 3

Accounting
Book Cover
10e
and Finance

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 Topics Covered

3.1 The Balance Sheet

3.2 The Income Statement
3.3 The Statement of Cash Flows
3.4 Accounting Practice and Malpractice
3.5 Taxes

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 The Balance Sheet (1 of 5)

 Definition
– Financial statement that shows the value of
the firm’s assets and liabilities at a particular
time
– Measured from an accounting perspective.
– Assets are listed on the left.
– Liabilities are listed on the right.

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 The Balance Sheet (2 of 5)
The Main Balance Sheet Items

Current Assets Current Liabilities

• Cash & Securities • Payables
• Receivables • Short-term Debt
• Inventories
+
+ =
Long-term Liabilities
Fixed Assets
• Tangible Assets +
• Intangible Assets
Shareholders’ Equity

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 The Balance Sheet (3 of 5)
TABLE 3.1 Target’s balance sheet (figures in $ millions).
Year Year Year
Ending Ending Year Ending Ending
February February February 1 February 1
Assets 1 2020 1 2019 Liabilities and shareholders’ Equity 2020 2019
Current assets
Cash and marketable securities 2,577 1,556 Current liabilities
Receivables 498 632 Debt due for repayment 161 1,052
Inventories 8,992 9,497 Accounts payable 9,920 9,761
Other current assets 835 834 Other current liabilities 4,406 4,201
Total current assets 12,902 12,519 Total current liabilities 14,487 15,014
Fixed Assets Long-term debt 11,338 10,223
Tangible fixed assets Other long-term liabilities 5,121 4,756
Property, plant, and equipment 48,183 46,185
Less accumulated depreciation 19,664 18,687 Total liabilities 30,946 29,993
Net tangible fixed assets 28,519 27,498
Shareholders’ equity
Intangible asset (goodwill) 686 699 Common stock and other paid-in capital 6,268 6,085
Other assets 672 574 Retained earnings 5,565 5,212
Total shareholders’ equity 11,833 11,297
Total Assets 42,779 41,290
Total liabilities and shareholders’ equity 42,779 41,290

 Note: Column sums subject to rounding error.

 Source: Derived from Target annual reports.
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 The Balance Sheet (4 of 5)

 Common-Size Balance Sheet

– All items in the balance sheet are expressed as
a percentage of total assets

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 The Balance Sheet (5 of 5)
TABLE 3.2 Target’s common-size balance sheet (all items expressed as a
percentage of total assets).
Year Year Year Year
Ending Ending Ending Ending
February 1 February February February
Assets 2020 1 2019 Liabilities and shareholders’ Equity 1 2020 1 2019
Current assets Current liabilities
Cash and marketable securities 6.0% 3.8% Debt due for repayment 0.4% 2.5%
Receivables 1.2% 1.5% Accounts payable 23.2% 23.6%
Inventories 21.0% 23.0% Other current liabilities 10.3% 10.2%
Other current assets 2.0% 2.0% Total current liabilities 33.9% 36.4%
Total current assets 30.2% 30.3%
Long-term debt 26.5% 24.8%
Fixed Assets Other long-term liabilities 12.0% 11.5%
Tangible fixed assets
Property, plant, and equipment 112.6% 111.9% Total liabilities 72.3% 72.6%
Less accumulated depreciation 46.0% 45.3%
Net tangible fixed assets 66.7% 66.6% Shareholders’ equity
Common stock and other paid-in capital 14.7% 14.7%
Intangible asset (goodwill) 1.6% 1.7% Retained earnings 13.0% 12.6%
Other assets 1.6% 1.4% Total shareholders’ equity 27.7% 27.4%
Total Assets 100.0% 100.0% Total liabilities and shareholders’ equity 100.0% 100.0%

Source: Derived from Target annual reports.

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Book Values and Market Values (1 of 3)

 Book Values
– Value of assets or liabilities according to the
balance sheet
– Based on procedures for preparing financial
statements such as Generally Accepted Accounting
Principles (GAAP) in the U.S.
 Market Values
– The value of assets or liabilities according to
financial markets
 Equity and asset “market values” are usually
higher than their “book values”

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Book Values and Market Values (2 of 3)
Example
According to GAAP, your firm has equity worth $6
billion, debt worth $4 billion, assets worth $10
billion. The market values your firm’s 100 million
shares at $75 per share and the debt at $4 billion

Q: What is the market value of your assets?

A: Since (Assets = Liabilities + Equity), your assets
must have a market value of $11.5 billion

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Book Values and Market Values (3 of 3)
Example (continued)

Book Value Balance Sheet

Assets = $10 bil Debt = $4 bil
Equity = $6 bil

Market Value Balance Sheet

Assets = $11.5 bil Debt = $4 bil
Equity = $7.5 bil

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 The Income Statement (1 of 3)

 Definition
– Financial statement that shows the revenues,
expenses, and net income of a firm over a
period.
– Measured from an accounting perspective.

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 The Income Statement (2 of 3)
TABLE 3.3 Target’s income statement, year ending February 1, 2020.
$ Million % of Sales
Net sales 78,112 100.0%
Cost of goods sold 54,864 70.2%
Selling, general & administrative expenses 16,233 20.8%
Depreciation 2,357 3.0%
Earnings before interest and income taxes (EBIT) 4,658 6.0%
Other income 21 0.0%
Interest expense 477 0.6%
Taxable income 4,202 5.4%
Taxes 921 1.2%
Net income 3,281 4.2%
Allocation of net income
Dividends 1,330 1.7%
Addition to retained earnings 1,951 2.5%
Source: Derived from Target annual reports. 3- 12
 The Income Statement (3 of 3)

 Earnings Before Interest and Taxes (EBIT)

EBIT = total revenues − costs − depreciation
= 78,112 − (54,864 + 16,233) − 2,357
= $4,658 million

Source: Target’s Income Statement (February 1, 2020)

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 Profits vs. Cash Flows

 Differences
– “Profits” ignore capital expenditures (these are
capitalized in the balance sheet)
– “Profits” subtract depreciation (a non-cash
expense)
– “Profits” record income and expenses at the
time of sales, not when the cash exchanges
actually occur
– “Profits” do not consider changes in working
capital

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The Statement of Cash Flows (1 of 4)

 Definition
– Financial statement that shows the firm’s cash
receipts and cash payments over a period of
time.
– It starts with profits and converts them to cash
flows.

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The Statement of Cash Flows (2 of 4)
TABLE 3.4 Target’s statement of cash flows, year ending February 2020
(figures in millions of dollars).

Cash provided by operations:

Net income 3,281
Depreciation 2,604
Changes in working capital items
Decrease (increase) in accounts receivable 134
Decrease (increase) in inventories 505
Decrease (Increase) In other current assets 229
Increase (decrease) in accounts payable 159
Increase (decrease) in other current liabilities 205
Total decrease (increase) in working capital 1,232
Cash provided by operations 7,117

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The Statement of Cash Flows (3 of 4)
Cash flows from investments:
Capital expenditure (3,027)
Sales (acquisitions) of long-term assets 63
Other investing activities 20
Cash provided by (used for) investments (2,944)
Cash provided for (used by) financing activities:
Increase (decrease) in short-term debt (2,069)
Increase (decrease) in long-term debt 1,739
Dividends (1,330)
Issues (repurchases) of stock (1,415)
Other (77)
Cash provided by (used for) financing activities (3,152)
Net increase (decrease) in cash and cash equivalents 1,021
Source: Calculated from data in Target’s Annual Report.
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The Statement of Cash Flows (4 of 4)
Target’s Change in Cash Balance (February 1, 2020)
($ Millions)

Cash provided by operations $7,117

Cash provided by (used for) investments $(2,944)

Cash provided by (used for) financing activities $(3,152)

Net increase (decrease) in cash and cash equivalents $1021

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 Accounting Practice

 Revenue recognition
 Cookie-jar reserves
 Off-balance sheet assets and liabilities

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Corporate Tax Rates (2020)

Companies pay tax on their income. The

U.S. Tax Cuts and Jobs Act, passed in
December 2017, reduced the corporate tax
rate from 35% to 21%. Thus, for every
$100 that the company earns, it pays $21
in federal tax.

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 Taxes (1 of 5)
Example
Taxes and cash flows can be changed by the use of
debt. Firm A pays part of its profits as debt interest.
Firm B does not.

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 Taxes (2 of 5)

FOOD FOR THOUGHT

If you were both the debt and equity holders of the
firm, which would generate more cash flow to you?

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 Taxes (3 of 5)
FOOD FOR THOUGHT
If you were both the debt and equity holders of the
firm, which would generate more cash flow to you?

Firm A Firm B
Net income 47.4 79
+ Interest 40 0
Net cash flow 87.4 79

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 Personal Tax Rates (2021)

TABLE 3.6 Personal tax rates, 2021.

Taxable Income (dollars)

Taxable Income (dollars)
Married Taxpayers Filing Joint Marginal Tax Rate
Single Taxpayers
Returns
0 to 9,950 0 to 19,900 10%
9,950 to 40,525 19,900 to 81,050 12%
40,525 to 86,375 81,050 to 172,750 22%
86,375 to 164,925 172,750 to 329,850 24%
164,925 to 209,425 329,850 to 418,850 32%
209,425 to 523,600 418,850 to 628,300 35%
523,600 and above 628,300 and above 37%

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 Taxes (4 of 5)

 Taxes have a major impact on financial

decisions
 Marginal Tax Rate is the tax that the
individual pays on each extra dollar of
income
 Average Tax Rate is the total tax bill divided
by total income

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 Taxes (5 of 5)

Example - Taxes paid by single person making $50,000

Tax = (.10 × 9,950) + (.12 × 30,575) + (.22 × 9,475)

= 995 + 3,669 + 2,084.5
= $6,748.5

Average tax rate or

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