Chapter 2 – Financial Statements, Taxes, and Cash Flow
Using Google, Lycos, Yahoo or other favorite search engine, search the Internet for news stories from the past six months that have to do with financial statements and “cooking the books.” In the body of an e-mail, paste in the part of the news story most relevant to this chapter, explain why it is relevant, and give the link to the entire news story. Your e-mail should have at least 3 stories. Due along with other homework on Chapter 2.
Questionable accounting practices are constantly in the news today. Enron, WorldCom and others have made us all too aware of what clever, but unscrupulous, financial managers can do. In Chapter 2, we look at the difference between accounting value (or book value) and market value. We also examine the difference between accounting income and cash flow. Ferreting out the truth about cash flow from the financial statements can be the work of a detective, or in the case of New York State, an attorney general!
Part of cash flow is taxes paid. Many people confuse the marginal tax rate — the rate paid on the next dollar of income — with the average tax rate — the total tax paid divided by the total income. Part of what you will learn to do in this chapter is figure out, using the tax tables, the marginal tax rate, and the total tax that a corporation pays.
When you finish your study of this chapter, you should know:
- ANALYZE a financial statement and determine cash flow.
- DEFINE and DIFFERENTIATE cash flow and accounting income.
- ANALYZE a financial statement and CALCULATE marginal tax and average tax and tax rates.
- DEFINE and DIFFERENTIATE book value and market value.
The following are terms that you should be able to define perfectly when you finish studying this chapter. Make your flash cards and take them with you, reviewing them whenever you have a chance. You will be a happy test taker!
Average tax rate
Balance Sheet Identity
Cash flow from assets
Cash flow identity
Cash flow to creditors
Cash flow to stockholders
Change in Net Working Capital
Income statement equation
Marginal tax rate
Net Capital Spending
Net working capital
Operating cash flow
Be sure to know:
- Why book value is different from market value, and why the goal of financial management is to maximize market value.
- The difference between net income and cash flow and why it matters.
- The difference between the average tax rate and the marginal tax rate and why it matters.
- The top tax rate for corporations (35%)
- The cash flow identity.
Be prepared to answer questions, both orally and in writing, on these concepts in class.
Don’t forget! Homework is due by 6:30 PM on class day by e-mail to firstname.lastname@example.org! Don’t suffer a zero by being late.
Accountants have chosen to deal with verifiable historical data, rather than current market value, since current value is ephemeral, slippery and hard to pin down. An accounting statement is a statement of historical fact.
As financial managers, however, we have to understand what is, rather than what it was. Therefore, we try, whenever possible, to look at current market values, and cash flow rather than accounting income. You can’t understand one without the other.
While much of the homework for this chapter consisted of problems using numbers from the balance sheet and the income statement, solving those problems depended more on knowing the definitions than any great math or accounting skills. Keep using those index cards!
Since you have already taken accounting, you should know much of the material in this chapter. It is more in the nature of a refresher and a shift in perspective than any new information..