, CHAPTER 2 – REVIEWING FINANCIAL STATEMENTS
questions
LG2-1 1. List and describe the four major financial statements.
The four basic financial statements are:
1. The balance sheet reports a firm’s assets, liabilities, and equity at a particular point in time.
2. The income statement shows the total revenues that a firm earns and the total expenses the
firm incurs to generate those revenues over a specific period of time—generally one year.
3. The statement of cash flows shows the firm’s cash flows over a given period of time. This
statement reports the amounts of cash the firm generated and distributed during a particular time
period. The bottom line on the statement of cash flows―the difference between cash sources and
uses―equals the change in cash and marketable securities on the firm’s balance sheet from the
previous year’s balance.
4. The statement of retained earnings provides additional details about changes in retained
earnings during a reporting period. This financial statement reconciles net income earned during
a given period minus any cash dividends paid within that period to the change in retained
earnings between the beginning and ending of the period.
LG2-1 2. On which of the four major financial statements (balance sheet, income statement, statement of
cash flows, or statement of retained earnings) would you find the following items?
a. earnings before taxes - income statement
b. net plant and equipment - balance sheet
c. increase in fixed assets - statement of cash flows
d. gross profits - income statement
e. balance of retained earnings, December 31, 20xx - statement of retained earnings and balance sheet
f. common stock and paid-in surplus - balance sheet
g. net cash flow from investing activities - statement of cash flows
h. accrued wages and taxes – balance sheet
i. increase in inventory - statement of cash flows
LG2-1 3. What is the difference between current liabilities and long-term debt?
Current liabilities constitute the firm’s obligations due within one year, including accrued wages and
taxes, accounts payable, and notes payable. Long-term debt includes long-term loans and bonds with
maturities of more than one year.
LG2-1 4. How does the choice of accounting method used to record fixed asset depreciation affect
management of the balance sheet?
Firm managers can choose the accounting method they use to record depreciation against their
fixed assets. Two choices include the straight-line method and the modified accelerated cost
recovery system (MACRS). Companies often calculate depreciation using MACRS when they
figure the firm’s taxes and the straight-line method when reporting income to the firm’s
, Chapter 2 - Reviewing Financial Statements
stockholders. The MACRS method accelerates deprecation, which results in higher depreciation
expenses, lower taxable income, and lower taxes in the early years of a project’s life. The
straight-line method results in lower depreciation expenses, but also results in higher taxes in the
early years of a project’s life. Firms seeking to lower their cash outflows from tax payments will
favor the MACRS depreciation method.
LG2-1 5. What is bonus depreciation? How did the Tax Cuts and Jobs Act of 2017 temporarily extend
and modify bonus depreciation?
Since 2001, businesses have had the ability to immediately deduct a percentage of the acquisition
cost of qualifying assets as "bonus depreciation." This additional depreciation deduction was
allowed to encourage business investment. However, bonus depreciation was a temporary
provision; the rate would have been 50 percent in 2017, 40 percent in 2018, and 30 percent in
2019, before phasing out in 2020. The Tax Cuts and Jobs Act of 2017 extended and modified
bonus depreciation, allowing businesses to immediately deduct 100 percent of the cost of eligible
property in the year it is placed in service, through 2022. The amount of allowable bonus
depreciation will then be phased down over four years: 80 percent will be allowed for property
placed in service in 2023, 60 percent in 2024, 40 percent in 2025, and 20 percent in 2026.
MACRS or straight-line depreciation is applied to any costs that do not qualify for bonus
depreciation.
LG2-1 6. What are the costs and benefits of holding liquid securities on a firm’s balance sheet?
The more liquid assets a firm holds, the less likely the firm will be to experience financial
distress. However, liquid assets generate little or no profits for a firm. For example, cash is the
most liquid of all assets, but it earns little, if any, return for the firm. In contrast, fixed assets are
illiquid, but provide the means to generate revenue. Thus, managers must consider the trade-off
between the advantages of liquidity on the balance sheet and the disadvantages of having money
sit idle rather than generating profits.
LG2-2 7. Why can the book value and market value of a firm differ?
A firm’s balance sheet shows its book (or historical cost) value based on Generally Accepted
Accounting Principles (GAAP). Under GAAP, assets appear on the balance sheet at what the
firm paid for them, regardless of what assets might be worth today if the firm were to sell them.
Inflation and market forces make many assets worth more now than they were when the firm
bought them. So in most cases, book values differ widely from the market values for the same
assets—the amount that the assets would fetch if the firm actually sold them. For the firm’s
current assets—those that mature within a year―the book value and market value of any
particular asset will remain very close. For example, the balance sheet lists cash and marketable
securities at their market value. Similarly, firms acquire accounts receivable and inventory and
then convert these short-term assets into cash fairly quickly, so the book value of these assets is
generally close to their market value.
LG2-2 8. From a firm manager’s or investor’s point of view, which is more important―the book value of a
firm or the market value of the firm?
, Chapter 2 - Reviewing Financial Statements
Balance sheet assets are listed at historical cost. Managers would thus see little relation between the
total asset value listed on the balance sheet and the current market value of the firm’s assets.
Similarly, the stockowners’ equity listed on the balance sheet generally differs from the true market
value of the equity—in this case, the market value may be higher or lower than the value listed on the
firm’s accounting books. So, financial managers and investors often find that balance sheet values are
not always the most relevant numbers.
LG2-3 9. How did the Tax Cuts and Jobs Act of 2017 change corporate tax laws?
The Tax Cuts and Jobs Act (TCJA) of 2017 is the most recent revision of corporate tax laws and
represents one of the most significant changes in more than 30 years. The Act permanently lowers
corporate taxes from a progressive schedule that saw tax rates as high as 35 percent to a flat 21
percent starting in 2018.
LG2-3 10. What is the difference between an average tax rate and a marginal tax rate?
A firm can figure the average tax rate as the percentage of each dollar of taxable income that the
firm pays in taxes. From your economics classes, you can probably guess that the firm’s marginal
tax rate is the amount of additional taxes a firm must pay out for every additional dollar of
taxable income it earns.
LG2-3 11. How did the Tax Cuts and Jobs Act of 2017 change the tax deductibility of corporate
interest in debt?
The Tax Cuts and Jobs Act of 2017 contains a new limitation on the deductibility of net interest
expense (interest expense minus interest income) that exceeds 30 percent of a firm’s “adjusted
taxable income” starting in 2018. For tax years beginning before January 1, 2022, “adjusted taxable
income” is measured as a business’ EBITDA. For subsequent tax years, “adjusted taxable income” is
measured as EBIT, no longer including an add-back for depreciation and amortization. Thus,
beginning in 2022, the new limitation will become more severe. Prior corporate tax laws generally
allowed full deduction of interest paid or accrued by businesses.
LG2-3 12. How does the payment of interest on debt affect the amount of taxes the firm must pay?
Corporate interest payments appear on the balance sheet as an expense item, so we deduct the
allowable portion of interest payments from operating income when the firm calculates taxable
income. But, any dividends paid by corporations to their shareholders are not tax deductible. This is
one factor that encourages managers to finance projects with debt financing rather than to sell more
stock. Suppose one firm uses mainly debt financing and another firm, with identical operations, uses
mainly equity financing. The equity-financed firm will have very little interest expense to deduct for
tax purposes. Thus, it will have higher taxable income and pay more taxes than the debt-financed
firm. The debt-financed firm will pay fewer taxes and be able to pay more of its operating income to
asset funders, i.e., its bondholders and stockholders. So, as long as interest on debt is under the 30
percent allowable cap for tax deduction, even stockholders prefer that firms finance assets primarily
with debt rather than with stock.
questions
LG2-1 1. List and describe the four major financial statements.
The four basic financial statements are:
1. The balance sheet reports a firm’s assets, liabilities, and equity at a particular point in time.
2. The income statement shows the total revenues that a firm earns and the total expenses the
firm incurs to generate those revenues over a specific period of time—generally one year.
3. The statement of cash flows shows the firm’s cash flows over a given period of time. This
statement reports the amounts of cash the firm generated and distributed during a particular time
period. The bottom line on the statement of cash flows―the difference between cash sources and
uses―equals the change in cash and marketable securities on the firm’s balance sheet from the
previous year’s balance.
4. The statement of retained earnings provides additional details about changes in retained
earnings during a reporting period. This financial statement reconciles net income earned during
a given period minus any cash dividends paid within that period to the change in retained
earnings between the beginning and ending of the period.
LG2-1 2. On which of the four major financial statements (balance sheet, income statement, statement of
cash flows, or statement of retained earnings) would you find the following items?
a. earnings before taxes - income statement
b. net plant and equipment - balance sheet
c. increase in fixed assets - statement of cash flows
d. gross profits - income statement
e. balance of retained earnings, December 31, 20xx - statement of retained earnings and balance sheet
f. common stock and paid-in surplus - balance sheet
g. net cash flow from investing activities - statement of cash flows
h. accrued wages and taxes – balance sheet
i. increase in inventory - statement of cash flows
LG2-1 3. What is the difference between current liabilities and long-term debt?
Current liabilities constitute the firm’s obligations due within one year, including accrued wages and
taxes, accounts payable, and notes payable. Long-term debt includes long-term loans and bonds with
maturities of more than one year.
LG2-1 4. How does the choice of accounting method used to record fixed asset depreciation affect
management of the balance sheet?
Firm managers can choose the accounting method they use to record depreciation against their
fixed assets. Two choices include the straight-line method and the modified accelerated cost
recovery system (MACRS). Companies often calculate depreciation using MACRS when they
figure the firm’s taxes and the straight-line method when reporting income to the firm’s
, Chapter 2 - Reviewing Financial Statements
stockholders. The MACRS method accelerates deprecation, which results in higher depreciation
expenses, lower taxable income, and lower taxes in the early years of a project’s life. The
straight-line method results in lower depreciation expenses, but also results in higher taxes in the
early years of a project’s life. Firms seeking to lower their cash outflows from tax payments will
favor the MACRS depreciation method.
LG2-1 5. What is bonus depreciation? How did the Tax Cuts and Jobs Act of 2017 temporarily extend
and modify bonus depreciation?
Since 2001, businesses have had the ability to immediately deduct a percentage of the acquisition
cost of qualifying assets as "bonus depreciation." This additional depreciation deduction was
allowed to encourage business investment. However, bonus depreciation was a temporary
provision; the rate would have been 50 percent in 2017, 40 percent in 2018, and 30 percent in
2019, before phasing out in 2020. The Tax Cuts and Jobs Act of 2017 extended and modified
bonus depreciation, allowing businesses to immediately deduct 100 percent of the cost of eligible
property in the year it is placed in service, through 2022. The amount of allowable bonus
depreciation will then be phased down over four years: 80 percent will be allowed for property
placed in service in 2023, 60 percent in 2024, 40 percent in 2025, and 20 percent in 2026.
MACRS or straight-line depreciation is applied to any costs that do not qualify for bonus
depreciation.
LG2-1 6. What are the costs and benefits of holding liquid securities on a firm’s balance sheet?
The more liquid assets a firm holds, the less likely the firm will be to experience financial
distress. However, liquid assets generate little or no profits for a firm. For example, cash is the
most liquid of all assets, but it earns little, if any, return for the firm. In contrast, fixed assets are
illiquid, but provide the means to generate revenue. Thus, managers must consider the trade-off
between the advantages of liquidity on the balance sheet and the disadvantages of having money
sit idle rather than generating profits.
LG2-2 7. Why can the book value and market value of a firm differ?
A firm’s balance sheet shows its book (or historical cost) value based on Generally Accepted
Accounting Principles (GAAP). Under GAAP, assets appear on the balance sheet at what the
firm paid for them, regardless of what assets might be worth today if the firm were to sell them.
Inflation and market forces make many assets worth more now than they were when the firm
bought them. So in most cases, book values differ widely from the market values for the same
assets—the amount that the assets would fetch if the firm actually sold them. For the firm’s
current assets—those that mature within a year―the book value and market value of any
particular asset will remain very close. For example, the balance sheet lists cash and marketable
securities at their market value. Similarly, firms acquire accounts receivable and inventory and
then convert these short-term assets into cash fairly quickly, so the book value of these assets is
generally close to their market value.
LG2-2 8. From a firm manager’s or investor’s point of view, which is more important―the book value of a
firm or the market value of the firm?
, Chapter 2 - Reviewing Financial Statements
Balance sheet assets are listed at historical cost. Managers would thus see little relation between the
total asset value listed on the balance sheet and the current market value of the firm’s assets.
Similarly, the stockowners’ equity listed on the balance sheet generally differs from the true market
value of the equity—in this case, the market value may be higher or lower than the value listed on the
firm’s accounting books. So, financial managers and investors often find that balance sheet values are
not always the most relevant numbers.
LG2-3 9. How did the Tax Cuts and Jobs Act of 2017 change corporate tax laws?
The Tax Cuts and Jobs Act (TCJA) of 2017 is the most recent revision of corporate tax laws and
represents one of the most significant changes in more than 30 years. The Act permanently lowers
corporate taxes from a progressive schedule that saw tax rates as high as 35 percent to a flat 21
percent starting in 2018.
LG2-3 10. What is the difference between an average tax rate and a marginal tax rate?
A firm can figure the average tax rate as the percentage of each dollar of taxable income that the
firm pays in taxes. From your economics classes, you can probably guess that the firm’s marginal
tax rate is the amount of additional taxes a firm must pay out for every additional dollar of
taxable income it earns.
LG2-3 11. How did the Tax Cuts and Jobs Act of 2017 change the tax deductibility of corporate
interest in debt?
The Tax Cuts and Jobs Act of 2017 contains a new limitation on the deductibility of net interest
expense (interest expense minus interest income) that exceeds 30 percent of a firm’s “adjusted
taxable income” starting in 2018. For tax years beginning before January 1, 2022, “adjusted taxable
income” is measured as a business’ EBITDA. For subsequent tax years, “adjusted taxable income” is
measured as EBIT, no longer including an add-back for depreciation and amortization. Thus,
beginning in 2022, the new limitation will become more severe. Prior corporate tax laws generally
allowed full deduction of interest paid or accrued by businesses.
LG2-3 12. How does the payment of interest on debt affect the amount of taxes the firm must pay?
Corporate interest payments appear on the balance sheet as an expense item, so we deduct the
allowable portion of interest payments from operating income when the firm calculates taxable
income. But, any dividends paid by corporations to their shareholders are not tax deductible. This is
one factor that encourages managers to finance projects with debt financing rather than to sell more
stock. Suppose one firm uses mainly debt financing and another firm, with identical operations, uses
mainly equity financing. The equity-financed firm will have very little interest expense to deduct for
tax purposes. Thus, it will have higher taxable income and pay more taxes than the debt-financed
firm. The debt-financed firm will pay fewer taxes and be able to pay more of its operating income to
asset funders, i.e., its bondholders and stockholders. So, as long as interest on debt is under the 30
percent allowable cap for tax deduction, even stockholders prefer that firms finance assets primarily
with debt rather than with stock.
