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CHAPTER

TWO

Review of Accounting

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PPT 2-1

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Table 2-1
KRAMER CORPORATION

Income Statement
For the Year Ended December 31, 1999

Block
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1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.

Sales . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . .
Gross Profits . . . . . . . . . . . . .
Selling and administrative expense . . . .
Amortization expense . . . . . . . . . .
Operating profit (EBIT)* . . . . . . . .
Interest expense . . . . . . . . . . . .
Earnings before taxes (EBT) . . . . . . .
Taxes . . . . . . . . . . . . . . . . .
Earnings after taxes (EAT) . . . . . . . .
Preferred stock dividends . . . . . . . .
Earnings available to common shareholders.
Shares outstanding . . . . . . . . . . .
Earnings per share . . . . . . . . . . .

$2,000,000
1,500,000
500,000
220,000
50,000
230,000
20,000
210,000
99,500
110,500
10,500
$ 100,000
100,000
$1.00

*Earnings before interest and taxes.


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Table 2-3
Price-earnings ratios for selected Canadian companies

Corporation
Abitibi . . . .
BCE . . . . .
Bank of Montreal
Imasco . . . .
Loblaw . . .
Molson . . . .
Open Text . . .
Pan Canadian .
TSE 300 Index

Industry
.
.
.
.
.
.
.
.

Forest Products
Telecommunications
Banking
Tobacco Products
Grocery Chain
Brewery
Tech. Software
Petroleum

Dec.
1981

Sept.
1992

Nov.
1995

Mar.
1999

3.7
7.8
3.9
7.4
6.2
9.1

11.2
8.8
13.8
18.5
13.5

21.1
14.9
8.6
11.0
18.1
22.2

10.3
8.6

143.4
110.2

23.3
13.2

24.8
13.8
20.4
41.8
6.4
443.8
29.2
24.6

Note: No P/E ratios are reported on negative earnings .


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Table 2-4a
KRAMER CORPORATION
Statement of Financial Position (Balance Sheet)
December 31, 1999
Assets
Current assets:
Cash . . . . . . . . .
Marketable securities . . . .
Accounts receivable . . . .
Less: Allowance for bad debts
Inventory . . . . . . .
Prepaid expenses . . . . .
Total current assets . . .

Block
Hirt
Short

.
.
.
.
.
.
.

Other assets:
Investments . . . . . . . .
Capital assets:
Plant and equipment, original cost. .
Less: Accumulated amortization
Net plant and equipment . . . .
Total assets
. . . . . . . . .
McGraw-Hill Ryerson

.
.
.
.
.
.
.

$
$ 220,000
20,000

.
.
.
.
.

40,000
10,000
200,000
180,000
20,000
450,000
50,000

1,100,000
600,000
500,000
$1,000,000
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Table 2-4b
Liabilities and Shareholders Equity

Block
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Current liabilities:
Accounts payable . . . . .
Notes payable (bank indebtedness)
Accrued expenses . . . . .
Total current liabilities . .

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

Long-term liabilities:
Bonds payable, 2007 .
Total liabilities .

.
.

.
.

.
.

.
.

.
.

.
.

90,000
300,000

Shareholders equity:
Preferred stock, 500 shares . .
Common stock, 100,000 shares .
Retained earnings . . . . .
Total shareholders equity

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

50,000
350,000
300,000
700,000

. .

$1,000,000

.
.

.
.

Total liabilities and shareholders equity


McGraw-Hill Ryerson

$
.

80,000
100,000
30,000
210,000

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Table 2-5
Comparison of market value to book value per share, March, 1999
Market Value
per Share

Corporation
Abitibi . . . .
Bank of Montreal
BCE . . . . .
Imasco . . . .
Loblaw . . . .
Molson . . . .
PanCanadian . .
Open Text . . .
Rogers Comm. .
Stelco . . . . .

.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.

$12.15
64.50
62.05
33.25
39.75
21.60
17.20
32.40
27.20
8.50

Book Value
per Share
$15.66
32.32
18.70
8.56
6.94
16.60
10.79
4.62
(6.14)
13.47

Ratio of
Market Value
to Book Value
.78
2.00
3.32
3.88
5.73
1.30
1.59
7.01

0.63

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Figure 2-1
Illustration of concepts behind the statement of cash flows
Cash inflows

(1)

Generation of
funds in normal
operations

Cash flows from


operating activities

Sale of plant
and equipment
Liquidation of
long-term
investment

Cash flows from


investing activities

Sale of bonds,
common stock,
preferred stock,
and other
securities

Cash outflows
Expenditure of funds
in normal operations

(2)
Purchase of plant
and equipment
Long-term investment

(3)
Cash flows from
financing activities

Retirement or
repurchase of
bonds, common stock,
preferred stock, and
other securities
Payment of cash
dividends

Add items 1, 2, and


3 together to arrive at
net increase
(decrease) in cash

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Figure 2-2 / Steps in computing cash provided by operating


activities using the indirect method
Net income
+
Amortization and other non-cash items

Increase in current assets


+
Decrease in current assets
+
Increase in current liabilities

Decrease in current liabilities


equals
Block
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Cash provided by (used in) operating activities


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Table 2-6a
KRAMER CORPORATION
Comparative Balance Sheets
Year-End
1998

Year-End
1999

Assets
Current assets:
Cash . . . . . .
Marketable securities .
Accounts receivable (net)
Inventory
. . . .
Prepaid expenses . . .
Total current assets .

Block
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Short

.
.
.
.
.
.

.
.
.
.
.
.

Investments (long term)


. . .
Plant and equipment
. . . .
Less: Accumulated amortization
Net plant and equipment . . .
Total assets . . . . . . .
McGraw-Hill Ryerson

.
.
.
.
.
.

.
.
.
.
.
.

30,000
10,000
170,000
160,000
30,000
400,000

.
.
.
.
.

.
.
.
.
.

20,000
1,000,000
550,000
450,000
$ 870,000

40,000
10,000
200,000
180,000
20,000
450,000

50,000
1,100,000
600,000
500,000
$ 1 ,000,000
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Table 2-6b
KRAMER CORPORATION
Comparative Balance Sheets
Liabilities and Shareholders Equity

Block
Hirt
Short

Current liabilities:
Accounts payable . . . . . .
Notes payable
. . . . . .
Accrued expenses . . . . . .
Total current liabilities .
Long-term liabilities:
Bonds payable, 2007 . . . . . .
Total liabilities . . .
Shareholders equity:
Preferred stock,
. . . . . .
Common stock, . . . . . . .
Retained earnings . . . . . .
Total shareholders equity

Year-End
1998

.
.
.
.

. $ 45,000
.
100,000
.
35,000
.
180,000

.
.

.
.

40,000
220,000

90,000
300,000

.
.
.
.

.
.
.
.

50,000
350,000
250,000
650,000

50,000
50,000
300,000
700,000

. $ 870,000

$ 1,000,000

Total liabilities and shareholders equity .


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Year-End
1999

80,000
100,000
30,000
210,000

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Table 2-7
Cash flows from operating activities
Operating Activities
Net income (earnings aftertaxes) (Table 2-1) . .
Add items not requiring an outlay of cash:
Amortization (Table 2-1) . . . . . . . . .
Cash flow from operations . . . . . . . . . .
Changes in non-cash working capital:
Increase in accounts receivable (Table 2-6) .
Increase in inventory (Table 2-6) . . . . .
Decrease in prepaid expenses (Table 2-6) . .
Increase in accounts payable (Table 2-6) . .
Decrease in accrued expenses (Table 2-6). .
Net change in non-cash working capital . . . .
Cash provided by (used in) operating activities.

McGraw-Hill Ryerson

. . .

$110,500

. . . . $50,000
. . . .
$160,500
.
.
.
.
.
.

.
.
.
.
.
.

.
.
.
.
.
.

.
.
.
.
.

. . .

(30,000)
(20,000)
10,000
35,000
(5,000)
10,000
$150,500

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Table 2-10a
KRAMER CORPORATION
Statement of Cash Flows
For the Year Ended December 31, 1999

Block
Hirt
Short

Operating Activities
Net income (earnings aftertaxes) . . . . . .
Add items not requiring an outlay of cash:
Amortization
. . . . . . . .
Cash flow from operations
Changes in non-cash working capital
Increase in accounts receivable . . . . . .
Increase in inventory .
. . . . . . . .
Decrease in prepaid expenses . . . . . .
Increase in accounts payable . . . . . . .
Decrease in accrued expenses . . . . . .
Net change in non-cash working capital . . .
Cash provided by (used in) operating activities .

McGraw-Hill Ryerson

. . .

$ 110,500

. . . $ 50,000
160,500
.
.
.
.
.
.
.

.
.
.
.
.
.
.

.
.
.
.
.
.
.

(30,000)
(20,000
10,000
35,000
(5,000)
10,000
$ 150,500

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Table 2-10b
Investing Activities:
Increase in investments (long-term securities) . . . ($ 30,000)
Increase in plant and equipment . . . . . . . . . (100,000)
Cash used in investing activities . . . . . . . . . .
($130,000)
Financing Activities:
Increase in bonds payable . . .
Preferred stock dividends paid .
Common stock dividends paid .
Cash used in financing activities

Block
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.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

50,000
(10,500)
(50,000)
(10,500)

Net increase (decrease) in cash and cash equivalents during the year
10,000
Cash and cash equivalents, beginning of year . . . .
30,000
Cash and cash equivalents, end of year . . . . . . .
$ 40,000
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Table 2-11a
Comparison of accounting and cash flows
Year 1
(A)
(B)
Accounting Flows Cash Flows
Earnings before amortization and taxes (EBAT) .
Amortization . . . . . . . . . . .

.
.

$1,000
100

$1,000
100

Earnings before taxes (EBT)


Taxes . . . . . . .

.
.

.
.

.
.

.
.

.
.

.
.

.
.

900
400

900
400

Earnings aftertaxes (EAT) . . . . .


Purchase of equipment . . . . . .
Amortization charged without cash outlay
Cash flow
. . . . . . . . .

.
.
.
.

.
.
.
.

.
.
.
.

$ 500

500
-500
+100
$ 100

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Table 2-11b
Comparison of accounting and cash flows
Year 2
(A)
(B)
Accounting Flows Cash Flows

Earnings before amortization and taxes (EBAT) . .


Amortization . . . . . . . . . . .

$1,000
100

$1,000
100

Earnings before taxes (EBT) . . . .


Taxes . . . . . . . . . .
Earnings aftertaxes (EAT) . . . . .
Amortization charged without cash outlay
Cash flow . . . . . . . . .

900
400
$ 500

900
400
500
+100
$ 600

.
.
.
.
.

.
.
.
.
.

.
.
.
.

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Chapter 2 - Outline

LT 2-1

Income Statement (I/S)


P/E Ratio
Balance Sheet (B/S)
Statement of Cash Flows (CFs)
Income Tax considerations

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Income Statement

LT 2-2

An Income Statement shows profitability for a


period (ex.; 1 year). Can be prepared in steps:
(1) Sales - Cost of Goods Sold (COGS) = Gross Profit (GP)

(2) GP - Operating Expenses = Earnings Before Interest and


Taxes (EBIT) or Operating Income (OI)
(3) EBIT - Interest = Earnings Before Taxes (EBT)
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(4) EBT - Taxes = Earnings Aftertaxes (EAT) or Net Income


(NI)
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P/E Ratio

LT 2-3

P/E Ratio = Price/Earnings Ratio


P/E Ratio = Market Price of Stock / Earnings per
share (EPS)
Way of measuring desirability of a stock. If
market expects better than average returns from
company, its P/E ratio will be higher
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Balance Sheet

LT 2-4

A Balance Sheet (B/S) shows what a firm


owns and how it is financed at a point in
time (ex.; December 31)
Remember the ALOE!
Assets = Liabilities + Owners Equity
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Statement of Cash Flows

LT 2-5

The Statement of Cash Flows (CFs) measures the


flow of cash into and out of a firm
CF from operating activities PLUS
CF from financing activities PLUS
CF from investing activities EQUALS
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Net increase (decrease) in cash


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Income Tax Considerations

LT 2-6

Income taxes affect financial decisions


For instance, corporate taxes vary by province, by
type of business and by size of business
Cash flows aftertax are most relevant for decisionmaking
Aftertax investment income paid to shareholders
or other individuals varies depending upon the
form of the income
Expenses deductible from taxable income provide
a tax shield (tax savings)
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Tax Treatment of Interest,


Dividends, and Capital Gains
Monies received . . . .

LT 2-7

Interest

Dividend

Capital Gain

$1,000.00

$1,000.00

$1,000.00

Gross -up
(dividends by 25%) . . .
Taxable capital gain
(75% of capital gain) . . .

250.00

$1,000.00

$1,250.00

750.00
$750.00

Federal tax (29%) . . . . .


Dividend tax credit
(13 1/3% of grossed-up income)

290.00

362.50

217.50

Federal tax payable . . .


.
Provincial tax payable (50%)

290.00

195.80

217.50

145.00

97.90

108.75

Total income tax payable

435.00

293.70

326.25

$565.00

$706.30

$673.75

Taxable income . . . .

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Aftertax income . .
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. .

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Amortization (Capital Cost allowance)


as a Tax Shield
Corporation A

Corporation B

$400,000

$400,000

100,000

Earnings before taxes .


Taxes (40%) . . . . .

300,000
120,000

400,000
160,000

Earnings aftertaxes

180,000

240,000

100,000
280,000

0
240,000

Earnings before
amortization and taxes .
Amortization (capital cost
allowance) . . . . . .

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LT 2-8

. .

+ amortization charged
without cash outlay . . .
Cash flow . . . . . . .
Difference - $40,000
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