Financial Statements

Prepared byPrepared byKen HartviksenKen Hartviksen

INTRODUCTION TOINTRODUCTION TO CORPORATE FINANCECORPORATE FINANCELaurence Booth Laurence Booth •• W. Sean Cleary W. Sean Cleary

Chapter 3 – Financial StatementsChapter 3 – Financial Statements

CHAPTER 3CHAPTER 3 Financial StatementsFinancial Statements

CHAPTER 3 – Financial Statements 3 - 3

Lecture AgendaLecture Agenda

• Learning ObjectivesLearning Objectives• Important TermsImportant Terms• Accounting PrinciplesAccounting Principles• Organizing a Firm’s TransactionsOrganizing a Firm’s Transactions• Preparing Accounting StatementsPreparing Accounting Statements• The Canadian Tax SystemThe Canadian Tax System• Summary and ConclusionsSummary and Conclusions

– Concept Review QuestionsConcept Review Questions


Learning ObjectivesLearning Objectives

1.1. The importance of preparing financial statements in The importance of preparing financial statements in accordance with a given set of guidelines or principles, accordance with a given set of guidelines or principles, and what the most important principles areand what the most important principles are

2.2. The fact that preparing accounting statements involves The fact that preparing accounting statements involves the use of judgementthe use of judgement

3.3. How the basic financial statements for a company are How the basic financial statements for a company are constructedconstructed

4.4. The important information that can be found on a The important information that can be found on a company’s balance sheet, income statement and cash company’s balance sheet, income statement and cash flow statementflow statement

5.5. Why accounting income differs from income for tax Why accounting income differs from income for tax purposespurposes

6.6. How the capital cost allowance (CCA) system worksHow the capital cost allowance (CCA) system works7.7. How different forms of investment income are taxed for How different forms of investment income are taxed for

corporations and for individuals.corporations and for individuals.


Important Chapter TermsImportant Chapter Terms

• AmortizationAmortization• Balance sheetBalance sheet• Capital gainCapital gain• Capital lossCapital loss• Cash flow from Cash flow from

operationsoperations• Cash flow statementCash flow statement• CCA recaptureCCA recapture• Current assetsCurrent assets• DepreciationDepreciation• Free cash flowFree cash flow

• Generally accepted Generally accepted accounting principles accounting principles (GAAP)(GAAP)

• Half-year ruleHalf-year rule• Income statementIncome statement• LiquidityLiquidity• Operating lossOperating loss• Terminal lossTerminal loss• Traditional cash flowTraditional cash flow• Undepreciated capital cost Undepreciated capital cost

(UCC)(UCC)

Accounting and Accounting PrinciplesAccounting and Accounting Principles

Financial StatementsFinancial Statements


Importance of Understanding AccountingImportance of Understanding Accounting

• Accounting is an organized way of Accounting is an organized way of summarizing the activities of business.summarizing the activities of business.

• Internal and external users of accounting Internal and external users of accounting information rely on accounting information to information rely on accounting information to make decisions.make decisions.

• A strong understanding of accounting is A strong understanding of accounting is required of financial managers because they required of financial managers because they use that information to make significant use that information to make significant management decisions that will affect the management decisions that will affect the future financial reports of the organization.future financial reports of the organization.


Accounting PrinciplesAccounting Principles

• Generally Accepted Accounting Principals Generally Accepted Accounting Principals (GAAP) are contained in the CICA (GAAP) are contained in the CICA Handbook and have the force of law in Handbook and have the force of law in Canada.Canada.

• The Income Tax Act (ITA) requires use of The Income Tax Act (ITA) requires use of the CICA Handbook, except where the CICA Handbook, except where specifically, the Act requires other specifically, the Act requires other treatment.treatment.– This has led to the practice of Canadian This has led to the practice of Canadian

companies reporting to shareholders using CICA companies reporting to shareholders using CICA GAAP, and preparing separate financial GAAP, and preparing separate financial statements for Canada Revenue Agency (CRA)statements for Canada Revenue Agency (CRA)

• Reporting of financial performance in a Reporting of financial performance in a consistent manner over time and consistent manner over time and between firms enhances the usefulness between firms enhances the usefulness of those reports allowing comparative of those reports allowing comparative analysis.analysis.


Accounting PrinciplesAccounting PrinciplesInternational ConvergenceInternational Convergence

• Different countries have different accounting Different countries have different accounting standards:standards:– Canada – (CICA) Canadian Institute of Chartered Accountants Canada – (CICA) Canadian Institute of Chartered Accountants

HandbookHandbook– United States – (FASB) Financial Accounting Standards BoardUnited States – (FASB) Financial Accounting Standards Board– Japan – (ASBJ) Accounting Standards Board of JapanJapan – (ASBJ) Accounting Standards Board of Japan

• Given the growing importance of international trade, Given the growing importance of international trade, integration of product and financial markets, there is a integration of product and financial markets, there is a need for countries to move to a common set of need for countries to move to a common set of accounting standards.accounting standards.– (IASB) London-based International Accounting Standards Board (IASB) London-based International Accounting Standards Board

has been working with FASB and other accounting boards from has been working with FASB and other accounting boards from numerous countries to work toward a common standard.numerous countries to work toward a common standard.


Accounting PrinciplesAccounting PrinciplesRecent Accounting ScandalsRecent Accounting Scandals

• ENRONENRON– Bankruptcy of one of the largest U.S. firms because of Bankruptcy of one of the largest U.S. firms because of

financial statement misrepresentation involving the financial statement misrepresentation involving the external auditor (Arthur Andersen), management, and external auditor (Arthur Andersen), management, and financial partners including Merrill Lynch, Citigroup, financial partners including Merrill Lynch, Citigroup, CIBC and othersCIBC and others

• Other accounting/investment scandals Other accounting/investment scandals involving WorldCom, Tyco, Bristol-Myers, involving WorldCom, Tyco, Bristol-Myers, Nortel and others demonstrate that the Nortel and others demonstrate that the ENRON issue was not an isolated incident.ENRON issue was not an isolated incident.


Accounting PrinciplesAccounting PrinciplesImpact of Recent Accounting ScandalsImpact of Recent Accounting Scandals

• Investors base investment decisions and Investors base investment decisions and estimate the value of stock using accounting estimate the value of stock using accounting information.information.

• Recent accounting scandals where financial Recent accounting scandals where financial statements were found either to misstate the statements were found either to misstate the financial results, or later required revision has financial results, or later required revision has shaken the confidence of investors in shaken the confidence of investors in financial markets.financial markets.

• U.S. Congress in 2002 passed the Sarbanes-U.S. Congress in 2002 passed the Sarbanes-Oxley Act (SOX) in an attempt to restore Oxley Act (SOX) in an attempt to restore investor confidence. investor confidence.


Accounting PrinciplesAccounting PrinciplesMain Provisions Sarbanes-Oxley Act 2002Main Provisions Sarbanes-Oxley Act 2002

• Creation of the Public Company Accounting Oversight BoardCreation of the Public Company Accounting Oversight Board– Register and inspect public accounting firmsRegister and inspect public accounting firms– Establish audit standards Establish audit standards

• Separation of the audit function from other services Separation of the audit function from other services provided by auditing firmsprovided by auditing firms

• Improve governance standardsImprove governance standards– Separate board committees for finance and auditSeparate board committees for finance and audit– External auditors must report to the audit committeeExternal auditors must report to the audit committee– Audit committee independence (membership must be dominated by Audit committee independence (membership must be dominated by

external directors) and financial expertiseexternal directors) and financial expertise• Requires the annual report to indicate the state of the Requires the annual report to indicate the state of the

firm’s internal controls and assess their effectivenessfirm’s internal controls and assess their effectiveness• CEO and CFO must ‘certify’ that the firms financial CEO and CFO must ‘certify’ that the firms financial

statements “fairly present in all material respects, the statements “fairly present in all material respects, the operations and financial condition of the issuer”operations and financial condition of the issuer”


Organizing a Firm’s TransactionsOrganizing a Firm’s TransactionsBookkeeping Versus AccountingBookkeeping Versus Accounting

BookkeepingBookkeeping• is the mechanical act of managing and is the mechanical act of managing and

recording transactions.recording transactions.

AccountingAccounting• is the application of GAAP principles and is the application of GAAP principles and

conventions to the bookkeeping data to conventions to the bookkeeping data to produce financial statements that fairly produce financial statements that fairly represent the financial condition and represent the financial condition and operations of the economic entity.operations of the economic entity.


Organizing a Firm’s TransactionsOrganizing a Firm’s TransactionsAccounting Conventions: The Basic PrinciplesAccounting Conventions: The Basic Principles

The most basic principles of GAAP are:The most basic principles of GAAP are:1.1. The entity conceptThe entity concept

2.2. The going concern principleThe going concern principle

3.3. A period of analysisA period of analysis

4.4. A monetary valueA monetary value

5.5. The matching principleThe matching principle

6.6. Revenue recognitionRevenue recognition



The most basic principles of GAAP are:The most basic principles of GAAP are:1.1. The entity conceptThe entity concept

• The accounting is for a specific economic entityThe accounting is for a specific economic entity2.2. The going concern principleThe going concern principle

• The statements are prepared on the basis that the economic entity will The statements are prepared on the basis that the economic entity will continue to operate into the future (hence liquidation values, for example, continue to operate into the future (hence liquidation values, for example, are not relevant)are not relevant)

3.3. A period of analysisA period of analysis• Usually a fiscal year, although quarterly and monthly financial statements Usually a fiscal year, although quarterly and monthly financial statements

are also producedare also produced4.4. A monetary valueA monetary value

• Historical costs are used because the objectivity inherent in arms-length Historical costs are used because the objectivity inherent in arms-length transactionstransactions

5.5. The matching principleThe matching principle• Expenses incurred must be matched to the revenue earned in the period of Expenses incurred must be matched to the revenue earned in the period of

analysis.analysis.6.6. Revenue recognitionRevenue recognition

• Revenue is recognized when it has been earned (even though the cash Revenue is recognized when it has been earned (even though the cash may not yet have been received).may not yet have been received).



The major conventions of GAAP are:The major conventions of GAAP are:1.1. Procedures Procedures

2.2. Standards Standards

3.3. Consistency Consistency

4.4. MaterialityMateriality

5.5. DisclosureDisclosure



The major conventions of GAAP are:The major conventions of GAAP are:1.1. ProceduresProcedures

• Assets are on the left, liabilities and equities on the right-hand side Assets are on the left, liabilities and equities on the right-hand side of the balance sheet of the balance sheet

2.2. StandardsStandards• CICA Handbook CICA Handbook

3.3. Consistency Consistency • The firm should consistently apply the same accounting principles The firm should consistently apply the same accounting principles

over time to ensure comparability of financial statements from prior over time to ensure comparability of financial statements from prior periodsperiods

4.4. MaterialityMateriality• All significant information is disclosedAll significant information is disclosed

5.5. DisclosureDisclosure• The financial statements should fully and fairly disclose the firm’s The financial statements should fully and fairly disclose the firm’s

financial position. Objectivity, consistency and conformity to financial position. Objectivity, consistency and conformity to GAAP are all aspects of full disclosureGAAP are all aspects of full disclosure


Preparing Accounting StatementsPreparing Accounting StatementsThe Balance SheetThe Balance Sheet

• The balance sheet is a financial ‘snapshot’ at The balance sheet is a financial ‘snapshot’ at one point in time (usually on the last day of one point in time (usually on the last day of the firm’s fiscal year)the firm’s fiscal year)

• It is an ‘inventory’ of what the firm owns It is an ‘inventory’ of what the firm owns (assets) and how those assets were financed (assets) and how those assets were financed (liabilities and owners equity)(liabilities and owners equity)– Left-hand side lists assetsLeft-hand side lists assets– Right-hand side list liabilities and owners equityRight-hand side list liabilities and owners equity– Top to bottom items are listed from most liquid, to Top to bottom items are listed from most liquid, to

least liquidleast liquid


Preparing Accounting StatementsPreparing Accounting StatementsThe Balance Sheet – Basic StructureThe Balance Sheet – Basic Structure

ABC Corporation LimitedBalance Sheet

as at March 31, 200X

Cash 5 Accrued wages and taxes 5Marketable Securities 10 Accounts payable 5Accounts Receivable 10 Long-term debt 20Inventory 25 Common stock 40Net fixed assets 100 Retained earnings 80Total assets 150 Total liabilities and owners equity 150

Basic Balance Sheet Structure


Preparing Accounting StatementsPreparing Accounting StatementsThe Income StatementThe Income Statement

• Also known as the profit and loss statementAlso known as the profit and loss statement• Reports the income earned over a given Reports the income earned over a given

period of timeperiod of time– Usually prepared to report on one fiscal yearUsually prepared to report on one fiscal year– Can be prepared for a quarter of a year (3 months) or Can be prepared for a quarter of a year (3 months) or

even a montheven a month• Reports expenses incurred in order to earn Reports expenses incurred in order to earn

that income (application of the matching that income (application of the matching principle)principle)

• Shows sales, expenses and net profit for a Shows sales, expenses and net profit for a given period.given period.


Preparing Accounting StatementsPreparing Accounting StatementsThe Income Statement – Basic StructureThe Income Statement – Basic Structure

ABC Corporation LimitedIncome Statement

for the year ended March 31, 200X

Revenues $6,700,000Cost of goods sold 4,020,000Gross margin 2,680,000Selling and administrative expenses 1,500,000Earnings before Interest and Taxes 1,180,000Interest expense 450,000Earnings before tax 730,000Income taxes 233,600Net income $496,400

Dividends $100,000Retained earnings $396,400

Basic Income Statement Structure

Variable Costs

including direct

materials and direct

labour.








Fixed period costs

including salaries, rent

and depreciation.








Financing costs. Interest

expense is tax-

deductible.








Profit after tax may be

retained in whole or in part to be

reinvested in the firm and

fuel the firm’s growth.


Preparing Accounting StatementsPreparing Accounting StatementsChanging Accounting AssumptionsChanging Accounting Assumptions

• GAAP provides flexibility in the accounting treatment of GAAP provides flexibility in the accounting treatment of things such as:things such as:– When to recognize revenueWhen to recognize revenue– Capitalizing expenses as assets versus expensing expendituresCapitalizing expenses as assets versus expensing expenditures– Rates of accounting depreciationRates of accounting depreciation

• Managements may have strong pressures on them to Managements may have strong pressures on them to make the financial performance of the firm look as good make the financial performance of the firm look as good as possible (indeed often their personal compensation as possible (indeed often their personal compensation may be affected by the accounting results)may be affected by the accounting results)– Consequently, managements may seek to change accounting Consequently, managements may seek to change accounting

assumptions (within the limits allowed by GAAP) to suit their needs assumptions (within the limits allowed by GAAP) to suit their needs and current circumstances facing the firm.and current circumstances facing the firm.

• Any change in application of GAAP must be disclosed in the audited Any change in application of GAAP must be disclosed in the audited financial statements and could jeopardize the audit opinion offered by financial statements and could jeopardize the audit opinion offered by the external auditors.the external auditors.


Preparing Accounting StatementsPreparing Accounting StatementsTax StatementsTax Statements

• In Canada businesses must report to CRA and remit income In Canada businesses must report to CRA and remit income taxes in accordance with the Income Tax Act.taxes in accordance with the Income Tax Act.– They are required to use CCA instead of depreciationThey are required to use CCA instead of depreciation

• Firms in Canada also tend to produce a separate set of Firms in Canada also tend to produce a separate set of financial statements for shareholders, prepared in financial statements for shareholders, prepared in accordance with GAAP.accordance with GAAP.

• Because CCA is an ‘accelerated’ method of amortization, Because CCA is an ‘accelerated’ method of amortization, and because assets are often replaced more frequently and because assets are often replaced more frequently than they are fully depreciated, then than they are fully depreciated, then – Actual income tax liability in accordance with ITA using CCA is usually Actual income tax liability in accordance with ITA using CCA is usually

less than what is ‘estimated’ when reporting to shareholders.less than what is ‘estimated’ when reporting to shareholders.– This ‘inter-temporal’ difference in tax liability is called ‘deferred taxes’ This ‘inter-temporal’ difference in tax liability is called ‘deferred taxes’

and capitalized on balance sheets when reporting to shareholders.and capitalized on balance sheets when reporting to shareholders.

NOTE: deferred taxes DOES NOT mean that the firm hasn’t paid its full tax NOTE: deferred taxes DOES NOT mean that the firm hasn’t paid its full tax liability to the government…it has.liability to the government…it has.


Preparing Accounting StatementsPreparing Accounting StatementsAccounting Income, Income for Tax and Economic IncomeAccounting Income, Income for Tax and Economic Income

Accounting IncomeAccounting Income– Net profit arrived at using GAAP and accounting depreciationNet profit arrived at using GAAP and accounting depreciation

Income for Tax PurposesIncome for Tax Purposes– Net profit arrived at using GAAP and CCA in accordance with ITANet profit arrived at using GAAP and CCA in accordance with ITA

Economic IncomeEconomic Income– The amount of funds a firm could withdraw from the firm at the end of an The amount of funds a firm could withdraw from the firm at the end of an

accounting period, and leave the firm in the same income earning accounting period, and leave the firm in the same income earning position as it started the periodposition as it started the period

Generally:Generally:Accounting Income > Tax Income > Economic IncomeAccounting Income > Tax Income > Economic Income

– Accounting income is usually greater than income for tax because the CCA Accounting income is usually greater than income for tax because the CCA deductions are usually greater than accounting depreciationdeductions are usually greater than accounting depreciation

– Economic income is less than income for tax because CCA and accounting Economic income is less than income for tax because CCA and accounting depreciation amounts are based on historical cost, and this understates the depreciation amounts are based on historical cost, and this understates the amount of money the firm must retain, to replace its asset base at higher amount of money the firm must retain, to replace its asset base at higher replacement costs.replacement costs.


Preparing Accounting StatementsPreparing Accounting StatementsCash Flow StatementsCash Flow Statements

• Accounting profit may not reflect the cash flow reality Accounting profit may not reflect the cash flow reality facing the firm.facing the firm.

• The cash flow statement helps to provide a clearer The cash flow statement helps to provide a clearer picture of where cash is coming from and where it is picture of where cash is coming from and where it is going.going.

• Analysts are very interested in the cash flow realities Analysts are very interested in the cash flow realities of the firm because they realize that accounting of the firm because they realize that accounting profit is often not available to manage to pay bills.profit is often not available to manage to pay bills.

• There are two ways to calculate the cash flow There are two ways to calculate the cash flow statement:statement:1.1. Examine changes in the balance sheet accountsExamine changes in the balance sheet accounts2.2. Add by non-cash items to net income.Add by non-cash items to net income.


The Cash Flow StatementThe Cash Flow StatementChanges in Balance Sheet AccountsChanges in Balance Sheet Accounts

Sources of CashSources of Cash– Any decrease in an assetAny decrease in an asset– Any increase in a liabilityAny increase in a liability– Any increase in common stock (capital account)Any increase in common stock (capital account)– Any increase in retained earningsAny increase in retained earnings

Uses of CashUses of Cash– Any increase in an assetAny increase in an asset– Any decrease in a liabilityAny decrease in a liability


The Cash Flow StatementThe Cash Flow StatementChanges in Balance Sheet Accounts - ExampleChanges in Balance Sheet Accounts - Example

Sources and Uses of Funds for Jim's Widgets

Sources of FundsIncrease in payables $5,000Increase in accruals 1,000Increase in loans 10,000Increase in deferred taxes 1,500Increase in owner's equity 44,000Increased retained earnings 2,000 Total sources of cash 63,500

Uses of FundsIncrease in receivables $5,000Increase in inventory 2,000Increase in prepaid expenses 3,500Increase in machinery 28,000 Total uses of cash 38,500Increase in cash 25,000

Example of Sources and Uses of Funds


The Cash Flow StatementThe Cash Flow StatementNet Income Plus Non-cash ItemsNet Income Plus Non-cash Items

– Start with net incomeStart with net income– Add back the non-cash items in the income Add back the non-cash items in the income

statement (usually depreciation/amortization and statement (usually depreciation/amortization and deferred income taxes)deferred income taxes)


The Cash Flow StatementThe Cash Flow StatementNet Income Plus Non-cash Items - ExampleNet Income Plus Non-cash Items - Example

Cash Flow Statement for Jim's Widgets

Net income $2,000Depreciation 2,000Deferred income taxes 1,500Traditional cash flow 5,500Increase in receivables -5,000Increase in prepaids -3,500Increase in inventory -2,000Increase in accruals 1,000Increase in payables 5,000Increase in net working capital -$4,500Cash flow from operations 1,000Capital expenditures -30,000Free cash flow -29,000

Example of Cash Flow Statement

Income Taxation in CanadaIncome Taxation in Canada



The Canadian Tax SystemThe Canadian Tax System

• Federal and Provincial Governments in Canada tax Federal and Provincial Governments in Canada tax individuals and corporations based on income earned.individuals and corporations based on income earned.

• Corporations pay income taxes, and then, out of after-Corporations pay income taxes, and then, out of after-tax profit, distribute dividends to shareholders.tax profit, distribute dividends to shareholders.

• Dividends received by shareholders are taxed again as Dividends received by shareholders are taxed again as one form of personal investment income.one form of personal investment income.– Recognizing the double-taxation of dividends, dividends from Recognizing the double-taxation of dividends, dividends from

Canadian corporations are given some partial relief through the Canadian corporations are given some partial relief through the ‘dividend gross-up, tax credit system’ ‘dividend gross-up, tax credit system’

– Dividends received from non-Canadian companies do not qualify Dividends received from non-Canadian companies do not qualify for this special tax treatment.for this special tax treatment.


Corporate Income TaxationCorporate Income Taxation

• Corporate tax is paid at a ‘flat’ or fixed rate on ‘taxable Corporate tax is paid at a ‘flat’ or fixed rate on ‘taxable income’income’– Small businesses (income of $300,000 or less) face approximately (the Small businesses (income of $300,000 or less) face approximately (the

actual rate varies by province) a 20% tax on income (combined federal actual rate varies by province) a 20% tax on income (combined federal and provincial)and provincial)

• Companies are free to chose their own taxation year (fiscal Companies are free to chose their own taxation year (fiscal year) but once established cannot alter it without year) but once established cannot alter it without justification and approval.justification and approval.

• Taxable income generally is income earned during the fiscal Taxable income generally is income earned during the fiscal year less expenses incurred in order to earn that income.year less expenses incurred in order to earn that income.– The income statement shows that variable costs and period overhead The income statement shows that variable costs and period overhead

costs can be subtracted in determining EBITcosts can be subtracted in determining EBIT– For tax purposes, the ITA requires that the Capital Cost Allowance For tax purposes, the ITA requires that the Capital Cost Allowance

system be used instead of accounting depreciation (amortization)system be used instead of accounting depreciation (amortization)– Interest expense on debt borrowed to earn income is generally Interest expense on debt borrowed to earn income is generally

deductible from earnings before the tax is determined.deductible from earnings before the tax is determined.

The Capital Cost Allowance SystemThe Capital Cost Allowance System



CCACCA

Capital Cost Allowance (CCA) is the Capital Cost Allowance (CCA) is the ‘depreciation’ method used by taxpayers in ‘depreciation’ method used by taxpayers in Canada when reporting business income to Canada when reporting business income to CRA Canada Revenue Agency for tax CRA Canada Revenue Agency for tax purposes.purposes.


Importance of CCA to Financial Importance of CCA to Financial DecisionsDecisions

• Taxation issues must be explicitly addressed Taxation issues must be explicitly addressed in each financial decision you make.in each financial decision you make.

• Since CCA affects the net income from a Since CCA affects the net income from a business (and especially affects net cash business (and especially affects net cash flow), knowledge of the CCA system is flow), knowledge of the CCA system is essential for all business decision-makers.essential for all business decision-makers.


CCA gives rise to a ‘Tax Shield Benefit’ to CCA gives rise to a ‘Tax Shield Benefit’ to the Companythe Company

• CCA is a CCA is a non-cashnon-cash deduction from income that would otherwise deduction from income that would otherwise be subject to income taxation.be subject to income taxation.

• As a result of the CCA deduction, taxable income is reduced.As a result of the CCA deduction, taxable income is reduced.• This results in a savings in tax payable.This results in a savings in tax payable.• The tax shield benefits is equal to: T(CCA)The tax shield benefits is equal to: T(CCA)

t = corporate tax ratet = corporate tax rate

CCA = the dollar amount of CCA claimedCCA = the dollar amount of CCA claimed• A firm with a 40% corporate tax rate and a $2,000 CCA A firm with a 40% corporate tax rate and a $2,000 CCA

deduction will save $800 in taxes.deduction will save $800 in taxes.

$800 $2,00040%

CCA RateTax Corporate CCA on SavingsTax


Example:Example:Consider two firms that report $10,000 in earnings before CCA and taxes, face a 40% tax rate. One firm Consider two firms that report $10,000 in earnings before CCA and taxes, face a 40% tax rate. One firm

has no CCA to claim, the other can claim $2,000 in CCAhas no CCA to claim, the other can claim $2,000 in CCA

Company ACompany A Company BCompany BEarnings Before CCA & TaxEarnings Before CCA & Tax $10,000$10,000 $10,000$10,000

CCACCA 2,000 2,000 0 0

Taxable IncomeTaxable Income $ 8,000$ 8,000 $ 10,000$ 10,000

Taxes @ 40%Taxes @ 40% 3,2003,200 4,0004,000

Net IncomeNet Income $ 4,800$ 4,800 $ 6,000$ 6,000

Add back non-cash expenseAdd back non-cash expense 2,0002,000 0 0

Cash flow from OperationsCash flow from Operations $ 6,800$ 6,800 $ 6,000$ 6,000

Note that company A is better off by $800 because of the $2,000 non-cash deduction of CCA. That is the amount of taxes saved.

If you look at net income, Company A appears to be worse off, however, that is only an accounting illusion!!

Note that company A is better off by $800 because of the $2,000 non-cash deduction of CCA. That is the amount of taxes saved.

If you look at net income, Company A appears to be worse off, however, that is only an accounting illusion!!


CCA vs. Accounting DepreciationCCA vs. Accounting Depreciation

CCACCA• like assets are grouped like assets are grouped

into pools or classesinto pools or classes• the CCA rate used in each the CCA rate used in each

asset class is setout in the asset class is setout in the regulations to the Income regulations to the Income Tax Act and may or may Tax Act and may or may not reflect economic not reflect economic wastage of the assetwastage of the asset

• no estimate of useful life no estimate of useful life or of salvage valueor of salvage value

• as long as the firm as long as the firm remains in existence, and remains in existence, and assets remain in the pool, assets remain in the pool, residual UCC values will residual UCC values will remain in the pool.remain in the pool.

Accounting DepreciationAccounting Depreciation• choose the method that choose the method that

will best represent the will best represent the economic wastage of the economic wastage of the asset (declining balance, asset (declining balance, sum-of-the-year’s digits, sum-of-the-year’s digits, straight-line, etc.)straight-line, etc.)

• individual assets are individual assets are depreciateddepreciated

• estimate of useful life and estimate of useful life and salvage value is includedsalvage value is included


CCA Over Time - A Simple ExampleCCA Over Time - A Simple ExampleAssume you acquire a depreciable asset with a cost base of $100,000 and there are no Assume you acquire a depreciable asset with a cost base of $100,000 and there are no other assets in this pool. The CCA rate for the pool is 10%. Note you are allowed only other assets in this pool. The CCA rate for the pool is 10%. Note you are allowed only

1/2 the regular CCA rate on the net additions to the pool in the year of acquisition.1/2 the regular CCA rate on the net additions to the pool in the year of acquisition.

Year UCC of pool Addition CCA @ 10%1 $0 $100,000 $5,0002 95,000 0 9,5003 85,500 0 8,5504 76,950 0 7,695

etc.


CCA Tax Shield Over TimeCCA Tax Shield Over Time(Assume a corporate Tax Rate ‘T’ of 40%)(Assume a corporate Tax Rate ‘T’ of 40%)

Year UCC of pool Addition CCA @ 10% T(CCA)1 $0 $100,000 $5,000 $2,0002 95,000 0 9,500 3,8003 85,500 0 8,550 3,4204 76,950 0 7,695 3,0785 69,255 0 6,926 2,7706 62,330 0 6,233 2,4937 56,097 0 5,610 2,2448 50,487 0 5,049 2,0199 45,438 0 4,544 1,818


Tax Shield Over TimeTax Shield Over Time(A Graphical Representation)(A Graphical Representation)

0500

1000150020002500300035004000

Tax Shield

1 3 5 7 9 11 13 15 17 19

Year

T(CCA) at 10% on $100,000

Asymptotic Curve


ObservationsObservations

• In the foregoing you can now readily see:In the foregoing you can now readily see: CCA a firm claims changes each and every year on a CCA a firm claims changes each and every year on a

‘declining balance’-like basis‘declining balance’-like basis CCA provides the largest tax shields in the early years CCA provides the largest tax shields in the early years

of the asset’s lifeof the asset’s life residual values remain in the pool long after the asset residual values remain in the pool long after the asset

was acquired…this means that the firm will never fully was acquired…this means that the firm will never fully recoup the original cost of the asset … as the firm’s recoup the original cost of the asset … as the firm’s asset base ages, cash flows generated from CCA will asset base ages, cash flows generated from CCA will

not enable the firm to replace the original asset.not enable the firm to replace the original asset.


Disposition of Assets and CCADisposition of Assets and CCACapital GainsCapital Gains

• A taxable capital gain would occur if the firm A taxable capital gain would occur if the firm sold a depreciable asset for greater than it’s sold a depreciable asset for greater than it’s original cost.original cost.

Capital Gain = Original Cost Base - Salvage ValueCapital Gain = Original Cost Base - Salvage Value


Disposition of Assets and CCADisposition of Assets and CCARecapture of DepreciationRecapture of Depreciation

• If the salvage value of the asset exceeds the UCC of If the salvage value of the asset exceeds the UCC of the the poolpool there is a recapture of depreciation there is a recapture of depreciation

• recaptured depreciation is subject to taxrecaptured depreciation is subject to tax

Recaptured Depreciation = UCCRecaptured Depreciation = UCCpool pool - Salvage Value- Salvage Value


Disposition of Assets and CCADisposition of Assets and CCATerminal LossTerminal Loss

• When the last physical asset in the pool is sold and not When the last physical asset in the pool is sold and not replaced, the pool will be closed out. replaced, the pool will be closed out.

• If there is a positive balance remaining in the pool If there is a positive balance remaining in the pool after disposition, that balance is called a after disposition, that balance is called a terminal lossterminal loss and is deductible from income in that year….it is a and is deductible from income in that year….it is a non-cash deduction just like CCA.non-cash deduction just like CCA.


CRA Form for Capital Cost AllowanceCRA Form for Capital Cost AllowanceAn ExampleAn Example

Assume you want to calculate the CCA for Class Assume you want to calculate the CCA for Class Six (10% CCA rate) given an opening UCC of Six (10% CCA rate) given an opening UCC of $91,874; additions to the class of $32,880 $91,874; additions to the class of $32,880 and $25,000 as proceeds on disposals from and $25,000 as proceeds on disposals from the class.the class.

CCA = $9,581CCA = $9,581

1

Class number

2

Undepreciated capital cost (UCC) at the start of the

year

3

Cost of additions in

the year

4

Proceeds of dispositions in the year

5

UCC af ter additions

and dispositions (col. 2 plus 3

minus 4)

6

Adjustments for current year

additions (1/2 times (col. 3 minues 4)) If

negative, enter

7

Base amount for capital

cost allow ance

(col. 5 minus 6)

8

Rate %

9

CCA for the year (col. 7 times

8 or an adjusted amount)

10

UCC at the end of the

year (col. 5 minus 9)

6 91,874.00 32,880.00 25,000.00 99,754.00 3,940.00 95,814.00 10% 9,581.40 90,172.60


Personal Income TaxationPersonal Income Taxation

• Canadians are taxed on their world-wide incomeCanadians are taxed on their world-wide income• The taxation year is the calendar year, starting on The taxation year is the calendar year, starting on

January 1 and ending December 31January 1 and ending December 31• The personal tax system is a ‘progressive’ one…as The personal tax system is a ‘progressive’ one…as

taxable income increases, it is taxed at progressive taxable income increases, it is taxed at progressive higher rates. higher rates.

• Table 3 – 7 on the following slide illustrates the top Table 3 – 7 on the following slide illustrates the top marginal tax rates in Canada on investment income marginal tax rates in Canada on investment income (interest, dividends and capital gains).(interest, dividends and capital gains).

(Please see the following slide with Table 3 -7)(Please see the following slide with Table 3 -7)


The Canadian Tax SystemThe Canadian Tax SystemPersonal Income TaxationPersonal Income Taxation

Taxable Income Ordinary

Income

Capital

Gains

Eligible Non-eligible

Federal Only 29.00% 14.50% 14.55% 19.58%

Alberta 39.00% 19.50% 17.45% 25.21%British Columbia 43.70% 21.85% 18.47% 31.58%

Manitoba 46.40% 23.20% 23.83% 36.75%

New Brunswick* 46.95% 23.48% 23.18% 35.40%

Newfoundland and Labrador 48.64% 24.32% 32.52% 37.32%

Non-resident 42.92% 21.46% 21.53% 28.98%

Northwest Territories 43.05% 21.53% 18.25% 29.65%

Nova Scotia 48.25% 24.13% 28.35% 33.06%

Nunavut 40.50% 20.25% 22.24% 28.96%

Ontario 46.41% 23.20% 24.64% 31.34%

Prince Edward Island 47.37% 23.69% 24.44% 33.61%

Quebec 48.22% 24.11% 29.69% 36.35%

Saskatchewan 44.00% 22.00% 20.35% 30.83%Yukon 42.40% 21.20% 17.23% 30.49%

*New Brunsw ick's 2007 budget revised the top combined rates.

Table 3-7 Top 2007 Personal Tax Rates

Dividends


The Canadian Tax SystemThe Canadian Tax SystemPersonal Income Taxation of Investment IncomePersonal Income Taxation of Investment Income

Investment income can be earned by Investment income can be earned by investors in three different forms:investors in three different forms:

– InterestInterest– DividendsDividends– Capital gainsCapital gains


Taxation of Interest IncomeTaxation of Interest Income

• Interest income is taxed at the person’s personal Interest income is taxed at the person’s personal marginal tax rate (the same rate that employment and marginal tax rate (the same rate that employment and business income is taxed at)business income is taxed at)

• We use the ‘marginal’ rate because when a person We use the ‘marginal’ rate because when a person invests, they are seeking to add to income in the invests, they are seeking to add to income in the future…that added income will face the marginal tax future…that added income will face the marginal tax rate.rate.

• All sources of interest must be claimed each calendar All sources of interest must be claimed each calendar year (both cash interest received, and interest income year (both cash interest received, and interest income that has accrued)that has accrued)– Accrued interest is interest that has been earned, but not yet Accrued interest is interest that has been earned, but not yet

received (for example, from compound interest Canada Savings received (for example, from compound interest Canada Savings Bonds that have yet to be redeemed)Bonds that have yet to be redeemed)



Taxation of Interest IncomeTaxation of Interest IncomeOntario Tax Rates – Interest IncomeOntario Tax Rates – Interest Income

Lower Limit Upper

Limit

Basic Tax Rate on

Excess

Dividend

Income

Capital

Gains

$ - to $8,148 $ - 0.00% 0.00% 0.00%

$8,149 to 11,336 $ - 16.00 3.33 8.00$11,337 to 14,477 510 28.10 5.63 14.05

$14,478 to 34,010 1,393 22.05 4.48 11.03

$34,011 to 35,595 5,700 25.15 8.36 12.58

$35,596 to 59,882 6,098 31.15 15.86 15.58

$59,883 to 68,020 13,664 32.98 16.86 16.49

$68,021 to 70,559 16,348 35.39 19.88 17.70

$70,560 to 71,190 17,246 39.41 22.59 19.70

$71,191 to 115,739 17,495 43.41 27.59 21.70$115,740 and up 36,833 46.41 31.34 23.20

Source: Ernst & Young w ebsite: <w w w .ey.com>.

Table 3-6 Ontario Taxable Income

Marginal Rate on

Interest income is taxed at the

investor’s personal marginal rate.

All interest income, whether received

in cash or accrued is subject to tax in

each tax year.


Taxation of Dividend IncomeTaxation of Dividend Income

• Dividends from Canadian companies are Dividends from Canadian companies are taxed using the ‘gross-up, tax credit system’taxed using the ‘gross-up, tax credit system’– Cash dividends are grossed up by 45% and this total Cash dividends are grossed up by 45% and this total

amount is included in taxable incomeamount is included in taxable income– A federal dividend tax credit of 18.97% and provincial A federal dividend tax credit of 18.97% and provincial

dividend tax credit of 6.5% (Ontario) is deducted from dividend tax credit of 6.5% (Ontario) is deducted from taxes that would otherwise be payable.taxes that would otherwise be payable.

– The effect of this system is to effectively reduce the The effect of this system is to effectively reduce the marginal tax rate applied to dividend income.marginal tax rate applied to dividend income.



Taxation of DividendTaxation of Dividend

Lower Limit Upper

Limit

Basic Tax Rate on

Excess

Dividend

Income

Capital

Gains

$ - to $8,148 $ - 0.00% 0.00% 0.00%

$8,149 to 11,336 $ - 16.00 3.33 8.00$11,337 to 14,477 510 28.10 5.63 14.05

$14,478 to 34,010 1,393 22.05 4.48 11.03

$34,011 to 35,595 5,700 25.15 8.36 12.58

$35,596 to 59,882 6,098 31.15 15.86 15.58

$59,883 to 68,020 13,664 32.98 16.86 16.49

$68,021 to 70,559 16,348 35.39 19.88 17.70

$70,560 to 71,190 17,246 39.41 22.59 19.70

$71,191 to 115,739 17,495 43.41 27.59 21.70$115,740 and up 36,833 46.41 31.34 23.20



Marginal Rate on

The dividend gross-up, tax credit

system makes dividend income the lowest taxed

investment income in the lower tax

brackets.


Taxation of Capital Gain IncomeTaxation of Capital Gain Income

• Only realized capital gains are taxedOnly realized capital gains are taxed– This is a very important feature for high income earners who do This is a very important feature for high income earners who do

not need investment income to fund their everyday living not need investment income to fund their everyday living expenses…they can afford to wait to sell their investments expenses…they can afford to wait to sell their investments indefinitely…and indefinitely delay paying taxes on the capital indefinitely…and indefinitely delay paying taxes on the capital gainsgains

• 50% of a realized capital gain is subject to tax at the 50% of a realized capital gain is subject to tax at the person’s marginal tax rate.person’s marginal tax rate.

• Capital losses can only be used to offset taxable Capital losses can only be used to offset taxable capital gains.capital gains.



The Canadian Tax SystemThe Canadian Tax SystemPersonal Income Tax Rates – Capital GainsPersonal Income Tax Rates – Capital Gains

Lower Limit Upper

Limit

Basic Tax Rate on

Excess

Dividend

Income

Capital

Gains

$ - to $8,148 $ - 0.00% 0.00% 0.00%

$8,149 to 11,336 $ - 16.00 3.33 8.00$11,337 to 14,477 510 28.10 5.63 14.05

$14,478 to 34,010 1,393 22.05 4.48 11.03

$34,011 to 35,595 5,700 25.15 8.36 12.58

$35,596 to 59,882 6,098 31.15 15.86 15.58

$59,883 to 68,020 13,664 32.98 16.86 16.49

$68,021 to 70,559 16,348 35.39 19.88 17.70

$70,560 to 71,190 17,246 39.41 22.59 19.70

$71,191 to 115,739 17,495 43.41 27.59 21.70$115,740 and up 36,833 46.41 31.34 23.20



Marginal Rate on

At the higher marginal tax

brackets, taxpayers will

prefer to receive their investment

income in the form of capital gains

because they are taxed at a 23.2%

marginal rate.

Only ‘realized’ capital gains are subject to tax.


Internet LinksInternet Links

• Canada Revenue Agency – Canada Revenue Agency – CCA ClassesCCA Classes• Canada Revenue Agency – Canada Revenue Agency – CCA Depreciable Property DescribedCCA Depreciable Property Described• Canada Revenue Agency – Canada Revenue Agency – Tax FormsTax Forms• Canada Revenue Agency – Canada Revenue Agency – CCA Form 2006 and later yearsCCA Form 2006 and later years• About Capital Cost Allowance About Capital Cost Allowance (Small Business Canada)(Small Business Canada)

http://www.cra-arc.gc.ca/tax/business/topics/solepartner/reporting/capital/classes-e.html

http://www.cra-arc.gc.ca/tax/business/topics/solepartner/reporting/capital/depreciable-e.html

http://www.cra-arc.gc.ca/E/pbg/tf/5006-r/README.html

http://www.cra-arc.gc.ca/E/pbg/tf/t2sch8/README.html

http://sbinfocanada.about.com/cs/taxinfo/g/capcostallow.htm


Summary and ConclusionsSummary and Conclusions

In this chapter you have developed:In this chapter you have developed:– A basic overview of accounting statementsA basic overview of accounting statements

– An understanding of the importance of generally An understanding of the importance of generally accepted accounting principlesaccepted accounting principles

– An understanding of the Canadian tax system An understanding of the Canadian tax system and the importance of tax considerations in and the importance of tax considerations in financial decision-making.financial decision-making.

Concept Review QuestionsConcept Review Questions



Concept Review Question 1Concept Review Question 1GAAPGAAP

What does GAAP stand for? Who prescribes What does GAAP stand for? Who prescribes GAAP for Canadian companies?GAAP for Canadian companies?

Finding Ending UCC by FormulaFinding Ending UCC by Formula

Appendix AAppendix A


Finding Ending UCCFinding Ending UCC

• You can always do a detailed table to finding ending UCC given the assumption You can always do a detailed table to finding ending UCC given the assumption of maximum use of available CCA in each year…(see the following slide for a of maximum use of available CCA in each year…(see the following slide for a spreadsheet approach to finding the UCC at spreadsheet approach to finding the UCC at t t = 5 for a $100,000 net addition to = 5 for a $100,000 net addition to a pool with a CCA rate a pool with a CCA rate dd = 10%. = 10%.

• However, you can also use a formula:However, you can also use a formula:

50.329,62$

)6561)(.95(.000,100$

)9)(.95(.000,100$

)1.1)(2

1.1(000,100$

)1)(2

1(

5

5

45

155

10

UCC

UCC

UCC

UCC

dd

CUCC nn


Finding ending CCA using a full CCA Finding ending CCA using a full CCA ScheduleSchedule

1 Class

number

2 Undepreciated

capital cost (UCC) at the start of the

year

3 Cost of additions in

the year

4 Proceeds of

dispositions in the year (Use the low er of Original cost

or selling price)

5 UCC

after additions and

dispositions (col. 2 plus 3

minus 4)

6 Adjustments for

current year additions (1/2 times (col. 3 minues 4)) If

negative, enter "0"

7 Base amount for capital cost

allow ance (col. 5 minus 6)

8 Rate %

9 CCA for the year

(col. 7 times 8 or an adjusted

amount)

10 UCC at the end

of the year (col. 5 minus 9)

6 0.00 100,000.00 0.00 100,000.00 50,000.00 50,000.00 0.1 5,000.00 95,000.00 95,000.00 0.00 0.00 95,000.00 0.00 95,000.00 0.1 9,500.00 85,500.00

85,500.00 0.00 0.00 85,500.00 0.00 85,500.00 0.1 8,550.00 76,950.0076,950.00 0.00 0.00 76,950.00 0.00 76,950.00 0.1 7,695.00 69,255.0069,255.00 0.00 0.00 69,255.00 0.00 69,255.00 0.1 6,925.50 62,329.50


CopyrightCopyright

Copyright © 2007 John Wiley & Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights Sons Canada, Ltd. All rights reserved. Reproduction or reserved. Reproduction or translation of this work beyond that translation of this work beyond that permitted by Access Copyright (the permitted by Access Copyright (the Canadian copyright licensing Canadian copyright licensing agency) is unlawful. Requests for agency) is unlawful. Requests for further information should be further information should be addressed to the Permissions addressed to the Permissions Department, John Wiley & Sons Department, John Wiley & Sons Canada, Ltd.Canada, Ltd. The purchaser may The purchaser may make back-up copies for his or her make back-up copies for his or her own use only and not for distribution own use only and not for distribution or resale.or resale. The author and the The author and the publisher assume no responsibility publisher assume no responsibility for errors, omissions, or damages for errors, omissions, or damages caused by the use of these files or caused by the use of these files or programs or from the use of the programs or from the use of the information contained herein.information contained herein.

Financial Statements

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