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ample, you can see that the increase of $303 million in accounts receivable is subtracted
from income, because this represents sales that Pepsi includes in its income statement
even though it has not yet received payment from its customers. On the other hand,
Pepsi increased accounts payable by $253 million. The accountant deducted this figure
as part of the cost of the goods sold by Pepsi in 1998, even though Pepsi had not yet
paid for these goods. Thus the $253 million increase in accounts payable must be added
back to calculate the cash flow from operations.
We have pointed out that depreciation is not a cash payment; it is simply the ac-
countant™s allocation to the current year of the original cost of the capital equipment.
However, cash does flow out the door when the firm actually buys and pays for new
capital equipment. Therefore, these capital expenditures are set out in the second sec-
tion of the cash-flow statement. You can see that Pepsi spent $1,271 on new capital
equipment and $4,520 to purchase new businesses. It also raised $772 million on other
noncurrent assets. Total cash used by investments was $5,019 million.
Finally, the third section of the cash-flow statement shows the cash from financing
activities. Pepsi raised $2,762 million by issuing debt, but it used $1,815 million to buy
back its stock and $757 million to pay dividends to its stockholders.4
To summarize, the cash-flow statement tells us that Pepsi generated $3,212 million
from operations, it spent $5,019 million on new investments, and it raised a net amount
of $190 million in new finance. Pepsi spent more cash than it earned and raised. There-
fore, its cash balance fell by $1,617 million. To calculate this change in cash balance,
we subtract the uses of cash from the sources:
In millions
Cash flow from operations $3,212
“ Cash flow for new investment “ 5,019
+ Cash raised by new financing + 190
= Change in cash balance “ 1,617



Would the following activities increase or decrease the firm™s cash balance?
Self-Test 4
a. Inventories are increased
b. The firm reduces its accounts payable
c. The firm issues additional common stock
d. The firm buys new equipment




Accounting for Differences
While generally accepted accounting principles go a long way to standardize account-
ing practice in the United States, accountants still have some leeway in reporting earn-
ings and book values. Financial analysts have even more leeway in how to use those re-
ports; for example, some analysts will include profits or losses from extraordinary or
nonrecurring events when they report net income, but others will not. Similarly, ac-


4 You might think that interest payments also ought to be listed in this section. However, it is usual to include
interest in the first section with cash flow from operations. This is because, unlike dividends, interest pay-
ments are not discretionary. The firm must pay interest when a payment comes due, so these payments are
treated as a business expense rather than as a financing decision.
122 APPENDIX A


countants have discretion concerning the treatment of intangible assets such as patents,
trademarks, or franchises. Some believe that including these intangibles on the balance
sheet provides the best measure of the company™s value as an ongoing concern. Others
take a more conservative approach, and they exclude intangible assets. This approach is
better suited for measuring the liquidation value of the firm.
Another source of imprecision arises from the fact that firms are not required to in-
clude all their liabilities on the balance sheet. For example, firms are not always re-
quired to include as liabilities on the balance sheet the value of their lease obligations.5
They likewise are not required to include the value of several potential obligations such
as warrants6 sold to investors or issued to employees.
Even bigger differences can arise in international comparisons. Accounting practices
can vary greatly from one country to another. For example, in the United States firms
generally maintain one set of accounts that is sent to investors and a different set of ac-
counts that is used to calculate their tax bill.7 That would not be allowed in most coun-
tries. On the other hand, United States standards are more stringent in most other re-
gards. For example, German firms have far greater leeway than United States firms to
tuck money away in hidden reserve accounts.
When Daimler-Benz AG, producer of the Mercedes-Benz automobile, decided to list
its shares on the New York Stock Exchange in 1993, it was required to revise its ac-
counting practices to conform to United States standards. While it reported a modest
profit in the first half of 1993 using German accounting rules, it reported a loss of $592
million under the much more revealing United States rules, primarily because of dif-
ferences in the treatment of reserves.
Such differences in international accounting standards pose a problem for financial
analysts who attempt to compare firms using data from their financial statements. This
is why foreign firms must restate their financial results using the generally accepted ac-
counting principles (GAAP) of the United States before their shares can be listed on a
U.S. stock exchange. Many firms have been reluctant to do this and have chosen to list
their shares elsewhere.
Other countries allow foreign firms to be listed on stock exchanges if their financial
statements are prepared according to International Accounting Standards (IAS) rules,
which impose considerable uniformity in accounting practices and are nearly as reveal-
ing as U.S. standards. The nearby box reports on current negotiations for international
SEE BOX
accounting standards.
The lesson here is clear. While accounting values are often the starting point for the
financial analyst, it is usually necessary to probe more deeply. The financial manager
needs to know how the values on the statements were computed and whether there are
important assets or liabilities missing altogether.
The trend today is toward greater recognition of the market values of various assets
and liabilities. Firms are now required to acknowledge on the balance sheet the value of

5 Some airlines at times actually have not had any aircraft on their balance sheets because their aircraft
were all leased. In contrast, General Electric owns the world™s largest private airfleet because of its leasing
business.
6 A warrant is the right to purchase a share of stock from the corporation for a specified price, called the ex-

ercise price.
7 For example, in their published financial statements most firms in the United States use straight-line depre-
ciation. In other words, they make the same deduction for depreciation in each year of the asset™s life. How-
ever, when they calculate taxable income, the same companies usually use accelerated depreciation”that is,
they make larger deductions for depreciation in the early years of the asset™s life and smaller deductions in the
later years.
Accounting and Finance 123


unfunded pension liabilities and other postemployment benefits, such as medical bene-
fits.8 In addition, a growing (although still controversial) trend toward “market-value
accounting” would have them record many assets at market value rather than at histor-
ical book value.



Taxes
Taxes often have a major effect on financial decisions. Therefore, we should explain
how corporations and investors are taxed.

CORPORATE TAX
Companies pay tax on their income. Table A.4 shows that there are special low rates of
corporate tax for small companies, but for large companies (those with income over
$18.33 million) the corporate tax rate is 35 percent. Thus for every $100 that the firm
earns it pays $35 in corporate tax.
When firms calculate taxable income they are allowed to deduct expenses. These ex-
penses include an allowance for depreciation. However, the Internal Revenue Service
(IRS) specifies the rates of depreciation that the company can use for different types of
equipment.9 The rates of depreciation that are used to calculate taxes may differ from
the rates that are used when the firm reports its profits to shareholders.
The company is also allowed to deduct interest paid to debtholders when calculating
its taxable income, but dividends paid to shareholders are not deductible. These divi-
dends are therefore paid out of after-tax income. Table A.5 provides an example of how
interest payments reduce corporate taxes.

TABLE A.4
Taxable Income, Dollars Tax Rate, %
Corporate tax rates, 1999
0“50,000 15
50,001“75,000 25
75,001“100,000 34
100,001“18,333,333 Varies between 39 and 34 percent
Over 18,333,333 35


TABLE A.5
Firm A Firm B
Firms A and B both have
earnings before interest and EBIT 100 100
taxes (EBIT) of $100 million, Interest 40 0
but A pays out part of its Pretax income 60 100
profits as debt interest. This Tax (35% of pretax income) 21 35
reduces the corporate tax Net income 39 65
paid by A.

Note: Figures in millions of dollars.

8 When General Motors recognized the value of its postemployment obligations to GM employees, it resulted
in the largest quarterly loss in United States history.
9 We will tell you more about these allowances later.
FINANCE IN ACTION

A Hill of Beans
tancy™s aficionados. But they are both superior to the
The world cannot have a truly global financial system
IASC™s existing standards in two main ways. First, they
without the help of its accountants. They are letting in-
promote transparency by making firms attach to their
vestors down.
aggregate financial tables (such as the profit-and-loss
statement) a set of detailed notes disclosing exactly
The biggest impediment to a global capital market is not
how the main items (such as inventories and pension li-
volatile exchange rates, nor timid investors. It is that
abilities) are calculated. Second, they lay down rules on
firms from one country are not allowed to sell their
how to record certain transactions. In many cases,
shares in many others, including, crucially, in the United
there is no intellectually “ right” way to do this. The point
States. And the reason for that is the inability of different
is simply that there is a standard method, so that man-
countries to settle on an international standard for re-
agers cannot mislead investors by choosing the method
porting.
for themselves.
In order to change this, the International Accounting
Standards Committee has been trying for years to per-
Let the Markets Do the Talking
suade as many companies as possible to adopt its
standards, and to convince securities regulators such
If the merits of Anglo-American accounting are so obvi-
as America™s Securities and Exchange Commission to
ous, why has the IASC not adopted its standards? Even
let such firms list on their stock exchanges. But the
in their present state, the international standards are
IASC has so far failed to produce standards that the
more rigorous than many domestic ones, and therefore
SEC is willing to endorse. It should produce them now.
unpopular with local firms. But by introducing a rigor-
The purpose of accounting standards is simple: to
ous set of international standards, acceptable to the
help investors keep track of what managers are doing
SEC, the committee could unleash some interesting
with their money. Countries such as America and
competition. Companies which adopted the new stan-
Britain, in which managers are accountable to lots of
dards would enjoy the huge advantage of being able to
dispersed investors, have had to develop standards
sell their shares anywhere; those opting for less disclo-
that are more transparent and rigorous than those of
sure would be punished by investors. It is amazing how
other countries. And since the purpose of international
persuasive the financial markets can be.
standards is to encourage such markets on a global
scale, it makes sense to use these countries™ standards
as a guide. Source: © 1999 The Economist Newspaper Group. Reprinted with
British and American accounting standards have permission. Further reproduction prohibited. www.economist.com.
their respective flaws, debated ad nauseam by accoun-


The bad news about taxes is that each extra dollar of revenues increases taxable in-
come by $1 and results in 35 cents of extra taxes. The good news is that each extra dol-
lar of expense reduces taxable income by $1 and therefore reduces taxes by 35 cents.
For example, if the firm borrows money, every dollar of interest it pays on the loan re-
duces taxes by 35 cents. Therefore, after-tax income is reduced by only 65 cents.


Recalculate the figures in Table A.5 assuming that Firm A now has to make interest
Self-Test 5
payments of $60 million. What happens to taxes paid? Does net income fall by the ad-
ditional $20 million interest payment compared with the case considered in Table A.5,
where interest expense was only $40 million?


When firms make profits, they pay 35 percent of the profits to the Internal Revenue
Service. But the process doesn™t work in reverse; if the firm takes a loss, the IRS does
124
Accounting and Finance 125


not send it a check for 35 percent of the loss. However, the firm can carry the losses
back and deduct them from taxable income in earlier years, or it can carry them forward
and deduct them from taxable income in the future.10


PERSONAL TAX
Table A.6 shows the U.S. rates of personal tax. Notice that as income increases the tax
rate also increases. Notice also that the top personal tax rate is higher than the top cor-
porate rate.
The tax rates presented in Table A.6 are marginal tax rates. The marginal tax rate
MARGINAL TAX RATE
Additional taxes owed per is the tax that the individual pays on each extra dollar of income. For example, as a sin-
dollar of additional income. gle taxpayer, you would pay 15 cents of tax on each extra dollar you earn when your in-
come is below $25,750, but once income exceeds $25,750, you would pay 28 cents of
tax on each dollar of income up to an income of $62,450. For example, if your total in-
come is $40,000, your tax bill is 15 percent of the first $25,750 of income and 28 per-
cent of the remaining $14,250:
Tax = (.15 — $25,750) + (.28 — $14,250) = $7,852.50
The average tax rate is simply the total tax bill divided by total income. In this ex-
AVERAGE TAX RATE
Total taxes owed divided by ample it is $7,852.50/$40,000 = .196 = 19.6 percent. Notice that the average rate is
total income. below the marginal rate. This is because of the lower rate on the first $25,750.


What are the average and marginal tax rates for a single taxpayer with a taxable income
Self-Test 6
of $70,000? What are the average and marginal tax rates for married taxpayers filing
joint returns if their joint taxable income is also $70,000?

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