76 Part One Introduction

∙∙ The income statement measures the profitability of the company during the year. It shows the difference
between revenues and expenses.
∙∙ The statement of cash flows measures the sources and uses of cash during the year. The change in the com-
pany’s cash balance is the difference between sources and uses.

What is the difference between market and book values? (LO3-2)

∙∙ Book values are historical measures based on the original cost of an asset. For example, the assets in the
balance sheet are shown at their historical cost less an allowance for depreciation.
∙∙ Similarly, shareholders’ equity measures the cash that shareholders have contributed in the past or that the
company has reinvested on their behalf.
∙∙ In contrast, market value is the current price of an asset or liability. Firms naturally strive to build or
obtain assets that will have greater market value than book value (the cost of acquisition).

Why does accounting income differ from cash flow? (LO3-3)

∙∙ On the reported income statement, investment in fixed assets is not deducted immediately from income
but is instead spread (as charges for depreciation) over the expected life of the equipment.
∙∙ The accountant records revenues when the sale is made, rather than when the customer actually pays the
bill, and at the same time deducts production costs even though those costs may have been incurred
earlier.

What are the essential features of the taxation of corporate and personal income? (LO3-4)
∙∙ For most corporations, the marginal rate of tax on income is 21%.
∙∙ In calculating taxable income, the company deducts an allowance for depreciation and interest payments.
It cannot deduct dividend payments to the shareholders.
∙∙ Individuals are also taxed on their income, which includes dividends and interest on their investments.
∙∙ Individuals pay taxes on capital gains, but only when the investment is sold and the gain realized.

LISTING OF EQUATION
Shareholders’ equity = net assets = total assets − total liabilities​
3.1 ​

QUESTIONS AND PROBLEMS

® 1. Financial Statements. Earlier in the chapter, we characterized the balance sheet as providing
a snapshot of the firm at one point in time and the income statement as providing a video.
What did we mean by this? Is the statement of cash flow more like a snapshot or a video?
(LO3-1)
2. Balance Sheet. Balance sheet items are usually entered in order of declining liquidity. Place
each of the terms below in the appropriate place in the following balance sheet. (LO3-1)

Accounts payable Total current assets

Net fixed assets Accounts receivable
Debt due for repayment Total current liabilities
Cash and marketable securities Inventories
Equity Long-term debt
Chapter 3 Accounting and Finance 77

Assets Liabilities and Equity

a. f.
b. g.
c. h.
d. i.
e. j.
Total assets Total liabilities and equity

3. Balance Sheet. Construct a balance sheet for Sophie’s Sofas given the following data. What is
shareholders’ equity? (LO3-1)
Cash balances = $10,000
Inventory of sofas = $200,000
Store and property = $100,000
Accounts receivable = $22,000
Accounts payable = $17,000
Long-term debt = $170,000
4. Income Statement. A firm’s income statement included the following data. The firm’s average
tax rate was 20%. (LO3-1)
Cost of goods sold $8,000
Income taxes paid $2,000
Administrative expenses $3,000
Interest expense $1,000
Depreciation $1,000
a. What was the firm’s net income?
b. What must have been the firm’s revenues?
c. What was EBIT?
5. Balance Sheet/Income Statement. The year-end 2021 balance sheet of Brandex Inc. listed
common stock and other paid-in capital at $1,100,000 and retained earnings at $3,400,000. The
next year, retained earnings were listed at $3,700,000. The firm’s net income in 2022 was
$900,000. There were no stock repurchases during the year. What were the dividends paid by
the firm in 2022? (LO3-1)
6. Financial Statements. South Sea Baubles has the following (incomplete) balance sheet and
income statement. (LO3-1, LO3-4)

BALANCE SHEET AT END OF YEAR

(Figures in $ millions)
Assets 2021 2022 Liabilities and Shareholders’ Equity 2021 2022
Current assets $ 90 $140 Current liabilities $ 50 $ 60
Net fixed assets 800 900 Long-term debt 600 750

INCOME STATEMENT, 2022

(Figures in $ millions)
Revenue $1,950
Cost of goods sold 1,030
Depreciation 350
Interest expense 240

a. What is shareholders’ equity in 2021?

b. What is shareholders’ equity in 2022?
c. What is net working capital in 2021?
d. What is net working capital in 2022?
e. What are taxes paid in 2022? Assume the firm pays taxes equal to 21% of taxable income.
78 Part One Introduction

f. What is cash provided by operations during 2022? Pay attention to changes in net working
capital, using Table 3.4 as a guide.
g. Net fixed assets increased from $800 million to $900 million during 2022. What must have
been South Sea’s gross investment in fixed assets during 2022?
h. If South Sea reduced its outstanding accounts payable by $35 million during the year, what
must have happened to its other current liabilities?
7. Financial Statements. Here are the 2021 and 2022 (incomplete) balance sheets for Newble Oil
Corp. (LO3-1)

BALANCE SHEET AT END OF YEAR

(Figures in $ millions)
Assets 2021 2022 Liabilities and Shareholders’ Equity 2021 2022
Current assets $ 310 $ 420 Current liabilities $210 $240
Net fixed assets 1,200 1,420 Long-term debt 830 920

a. What was shareholders’ equity at the end of 2021?

b. What was shareholders’ equity at the end of 2022?
c. If Newble paid dividends of $100 in 2022 and made no stock issues, what must have been
net income during the year?
d. If Newble purchased $300 in fixed assets during 2022, what must have been the depreciation
charge on the income statement?
e. What was the change in net working capital between 2021 and 2022?
f. If Newble issued $200 of new long-term debt, how much debt must have been paid off
­during the year?
8. Financial Statements. Henry Josstick has just started his first accounting course and has pre-
pared the following balance sheet and income statement for Omega Corp. Unfortunately, although
the data for the individual items are correct, he is very confused as to whether an item should go
in the balance sheet or income statement and whether it is an asset or liability. Help him by rear-
ranging the items and filling in the blanks.

BALANCE SHEET
Payables $ 35 Inventories $50
Less accumulated depreciation 120 Receivables 35
Total current assets  Total current liabilities 
Long-term debt $350 Interest expense $25
Property, plant, and equipment 520 Total liabilities 
Net fixed assets  Shareholders’ equity $90
Total assets  Total liabilities and shareholders’ equity 

INCOME STATEMENT
Net sales $700
Cost of goods sold 580
Selling, general, and administrative expenses 38
EBIT 
Debt due for repayment $ 25
Cash 15
Taxable income 
Federal plus other taxes $ 15
Depreciation 12
Net income 

What is the correct total for the following? (LO3-1)

a. Current assets
b. Net fixed assets
c. Total assets
Chapter 3 Accounting and Finance 79

d. Current liabilities
e. Total liabilities
f. Total liabilities and shareholders’ equity
g. EBIT
h. Taxable income
i. Net income
9. Market versus Book Values. The founder of Alchemy Products Inc. discovered a way to turn
gold into lead and patented this new technology. He then formed a corporation and invested
$200,000 in setting up a production plant. He believes that he could sell his patent for
$50 million. (LO3-2)
a. What is the book value of the firm?
b. What is the market value of the firm?
c. If there are two million shares of stock in the new corporation, what is the book value per share?
d. What is the price per share?
10. Market versus Book Values. State whether each of the following events would increase or
decrease the ratio of market value to book value. (LO3-2)
a. Big Oil announces the discovery of a major new oil field in Costaguana.
b. Big Autos increases its depreciation provision.
c. Since Big Stores purchased its assets, inflation has risen sharply.
11. Market versus Book Values. (LO3-2)
a. In late 2020, the market value of the shares of Citigroup was less than book value per share.
How would you interpret this pattern?
b. At the same time, Apple’s market value per share was about 20 times its book value. Is this
consistent with your analysis in part (a)?
12. Income versus Cash Flow. Explain why accounting income generally differs from a firm’s
cash inflows. (LO3-3)
13. Cash Flows. Will the following actions increase or decrease the firm’s cash balance? (LO3-3)
a. The firm sells some goods from inventory.
b. The firm sells some machinery to a bank and leases it back for a period of 20 years.
c. The firm buys back 1 million shares of stock from existing shareholders.
14. Income versus Cash Flow. Butterfly Tractors had $14 million in sales last year. Cost of goods
sold was $8 million, depreciation expense was $2 million, interest payment on outstanding debt
was $1 million, and the firm’s tax rate was 21%. (LO3-3)
a. What was the firm’s net income?
b. What was the firm’s cash flow?
c. What would happen to net income and cash flow if depreciation were increased by $1 million?
d. Would you expect the change in depreciation to have a positive or negative impact on the
firm’s stock price?
e. What would be the impact on net income if depreciation was $1 million and interest expense
was $2 million?
f. What would be the impact on cash flow if depreciation was $1 million and interest expense
was $2 million?
15. Working Capital. QuickGrow is in an expanding market, and its sales are increasing by 25%
per year. Would you expect its net working capital to be increasing or decreasing? (LO3-3)
16. Income Statement. Sheryl’s Shipping had sales last year of $10,000. The cost of goods sold
was $6,500, general and administrative expenses were $1,000, interest expenses were $500, and
depreciation was $1,000. The firm’s tax rate is 21%. (LO3-3)
a. What are earnings before interest and taxes?
b. What is net income?
c. What is cash flow from operations?
17. Income versus Cash Flow. Start-up firms typically have negative net cash flows for several
years. (LO3-3)
a. Does this mean that they are failing?
b. Accounting profits for these firms are also commonly negative. How would you interpret
this pattern? Is there a shortcoming in our accounting rules?
80 Part One Introduction

18. Income versus Cash Flow. Can cash flow from operations be positive if net income is nega-
tive? Can it be negative if net income is positive? Give examples. (LO3-3)
19. Income versus Cash Flow. During the last year of operations, Theta’s accounts receivable
increased by $10,000, accounts payable increased by $5,000, and inventories decreased by
$2,000. What is the total impact of these changes on the difference between profits and cash
flow? (LO3-3)
20. Income versus Cash Flow. Candy Canes Inc. spends $100,000 to buy sugar and peppermint in
April. It produces its candy and sells it to distributors in May for $150,000, but it does not
receive payment until June. Assuming that sales in April and June are zero, fill in the following
table. (LO3-3)

Sales Net Income Cash Flow

April a. b. c.
May d. e. f.
June g. h. i.

21. Income versus Cash Flow. Ponzi Products produced 100 chain-letter kits this quarter, resulting
in a total cash outlay of $10 per unit. It will sell 50 of the kits next quarter at a price of $11, and
the other 50 kits in the third quarter at a price of $12. It takes a full quarter for Ponzi to collect
its bills from its customers. (Ignore possible sales in earlier or later quarters.) (LO3-3)
a. What is the net income for Ponzi next quarter?
b. What are the cash flows for the company this quarter?
c. What are the cash flows for the company in the third quarter?
d. What is Ponzi’s net working capital in the next quarter?
22. Income versus Cash Flow. Value Added Inc. buys $1 million of sow’s ears at the beginning of
January but doesn’t pay immediately. Instead, it agrees to pay the bill in March. It processes the
ears into silk purses, which it sells for $2 million in February. However, it will not collect pay-
ment on the sales until April. (LO3-3)
a. What is the firm’s net income in February?
b. What is its net income in March?
c. What is the firm’s net new investment in working capital in January?
d. What is its net new investment in working capital in April?
e. What is the firm’s cash flow in January?
f. What is the firm’s cash flow in February?
g. What is the cash flow in March?
h. What is the cash flow in April?
23. Free Cash Flow. Free cash flow measures the cash available for distribution to debtholders and
shareholders. Look at Section 3.3, where we calculate free cash flow for Target. Show how this
cash was distributed to investors. How much was used to build up cash reserves? (LO3-3)
24. Free Cash Flow. The following table shows an abbreviated income statement and balance sheet
for Quick Burger Corporation for 2022. (LO3-3)

INCOME STATEMENT OF QUICK BURGER CORP., 2022

(Figures in $ millions)
Net sales $27,567
Costs 17,569
Depreciation 1,402
Earnings before interest and taxes (EBIT) $ 8,596
Interest expense 517
Pretax income 8,079
Federal plus other taxes 2,614
Net income $ 5,465
 Chapter 3 Accounting and Finance 81

BALANCE SHEET OF QUICK BURGER CORP., 2022

(Figures in $ millions)
Assets 2022 2021 Liabilities and Shareholders’ Equity 2022 2021
Current assets Current liabilities
Cash and marketable securities $ 2,336 $ 2,336 Debt due for repayment — $ 367
Receivables 1,375 1,335 Accounts payable $ 3,403 3,143
Inventories 122 117 Total current liabilities $ 3,403 $ 3,509
Other current assets 1,089 616
Total current assets $ 4,922 $ 4,403
Fixed assets Long-term debt $13,633 $12,134
Property, plant, and equipment $24,677 $22,835 Other long-term liabilities 3,057 2,957
Intangible assets (goodwill) 2,804 2,653 Total liabilities $20,093 $18,600
Other long-term assets 2,983 3,099 Total shareholders’ equity 15,294 14,390
Total assets $35,387 $32,990 Total liabilities and shareholders’ equity $35,387 $32,990

In 2022 Quick Burger had capital expenditures of $3,049.

a. Calculate Quick Burger’s free cash flow in 2022.
b. If Quick Burger was financed entirely by equity, how much more tax would the company
have paid? (Assume a tax rate of 21%.)
c. What would the company’s free cash flow have been if it was all-equity financed?
25. Tax Rates. Use Table 3.6 to answer the following. (LO3-4)
a. What would be the marginal tax rate for a married couple with income of $90,000?
b. What would be the average tax rate for a married couple with income of $90,000?
c. What would be the marginal tax rate for an unmarried taxpayer with income of $90,000?
d. What would be the average tax rate for an unmarried taxpayer with income of $90,000?
26. Tax Rates. Using Table 3.6, calculate the marginal and average tax rates for a single taxpayer
with the following incomes: (LO3-4)
a. $20,000
b. $50,000
c. $300,000
d. $3,000,000
27. Taxes. A married couple earned $95,000 in 2021. How much did they pay in taxes? (LO3-4)
a. What was their marginal tax bracket?
b. What was their average tax bracket?
28. Tax Rates. What would be the marginal and average tax rates for a corporation with an income
level of $100,000? (LO3-4)
29. Tax Rates. You have set up your tax preparation firm as an incorporated business. You took
$80,000 from the firm as your salary. The firm’s taxable income for the year (net of your salary)
was $30,000. Assume you pay personal taxes as an unmarried taxpayer. (LO3-4)
a. How much tax must be paid to the federal government, including both your personal taxes
and the firm’s taxes? Use the tax rates presented in Table 3.6.
b. By how much will you reduce the total tax bill if you cut your salary to $50,000, thereby
leaving the firm with taxable income of $60,000?
c. What allocation will minimize the total tax bill? Hint: Think about marginal tax rates and
the ability to shift income from a higher marginal bracket to a lower one.
30. Tax Rates. Turn back to Table 3.6, which shows marginal personal tax rates. Make a table in
Excel that calculates taxes due for income levels ranging from $10,000 to $10 million.
(LO3-4)
a. For each income, calculate the average tax rate of a single taxpayer. Plot the average tax rate
as a function of income.
b. What happens to the difference between the average and top marginal tax rates as income
becomes very large?
82 Part One Introduction

The table below contains data on Fincorp Inc. that you should use for Problems 31–38. The balance
sheet items correspond to values at year-end 2021 and 2022, while the income statement items
correspond to revenues or expenses during the year ending in either 2021 or 2022. All values are in
thousands of dollars.

2021 2022
Revenue $4,000 $4,100
Cost of goods sold 1,600 1,700
Depreciation 500 520
Inventories 300 350
Administrative expenses 500 550
Interest expense 150 150
Federal and state taxes* 400 420
Accounts payable 300 350
Accounts receivable 400 450
Net fixed assets† 5,000 5,800
Long-term debt 2,000 2,400
Notes payable 1,000 600
Dividends paid 410 410
Cash and marketable securities 800 300

* Taxes are paid in their entirety in the year that the tax obligation is
incurred.
† Net fixed assets are fixed assets net of accumulated depreciation since
the asset was installed.

31. Balance Sheet. Construct a balance sheet for Fincorp for 2021 and 2022. What is shareholders’
equity? (LO3-1)
32. Working Capital. What was the change in net working capital during the year? (LO3-1)
33. Income Statement. Construct an income statement for Fincorp for 2021 and 2022. What were
reinvested earnings for 2022? (LO3-1)
34. Earnings per Share. Suppose that Fincorp has 500,000 shares outstanding. What were earn-
ings per share in 2022? (LO3-1)
35. Balance Sheet. Examine the values for depreciation in 2022 and net fixed assets in 2021 and
2022. What was Fincorp’s gross investment in plant and equipment during 2022? (LO3-1)
36. Book versus Market Value. Suppose that the market value (in thousands of dollars) of Fin-
corp’s fixed assets in 2022 is $6,000 and that the value of its long-term debt is only $2,200. In
addition, the consensus among investors is that Fincorp’s past investments in developing the
skills of its employees are worth $2,900. This investment, of course, does not show up on the
balance sheet. What will be the price per share of Fincorp stock? (LO3-2)
37. Income versus Cash Flows. Construct a statement of cash flows for Fincorp for 2022. (LO3-3)
38. Tax Rates. What was the firm’s average tax bracket for each year? (LO3-4)

WEB EXERCISES
1. Find Microsoft (MSFT) and Ford (F) on finance.yahoo.com, and examine the financial state-
ments of each. Which firm uses more debt finance? Which firm has higher cash as a percentage
of total assets? Which has higher EBIT per dollar of total assets? Which has higher profits per
dollar of shareholders’ equity?
2. Now choose two highly profitable technology firms, such as Amazon (AMZN) and Microsoft
(MSFT), and two electric utilities, such as American Electric Power (AEP) and Duke Energy
(DUK). Which firms have the higher ratio of market value to book value of equity? Does this
make sense to you? Which firms pay out a higher fraction of their profits as dividends to share-
holders? Does this make sense?
 Chapter 3 Accounting and Finance 83

3. Log on to the website of a large nonfinancial company and find its latest financial statements.
Draw up a simplified balance sheet, income statement, and statement of cash flows as in
Tables 3.1, 3.3, and 3.4. Some companies’ financial statements can be extremely complex; try
to find a relatively straightforward business. Also, as far as possible, use the same headings as
in these tables, and don’t hesitate to group some items as “other current assets,” “other
expenses,” and so on. Look first at your simplified balance sheet. How much was the com-
pany owed by its customers in the form of unpaid bills? What liabilities does the company
need to meet within a year? What was the original cost of the company’s fixed assets? Now
look at the income statement. What were the company’s earnings before interest and taxes
(EBIT)? Finally, turn to the cash-flow statement. Did changes in working capital add to cash
or use it up?
4. The schedule of tax rates for individuals changes frequently. If you search for federal tax
brackets on the web, you will find many sites with up-to-date information. What is your
marginal tax rate if you are single with a taxable income of $70,000? What is your average
tax rate?

SOLUTIONS TO SELF-TEST QUESTIONS

3.1 Cash and equivalents would increase by $100 million. Property, plant, and equipment would
increase by $400 million. Long-term debt would increase by $500 million. Shareholders’
equity would not increase: Assets and liabilities have increased equally, leaving shareholders’
equity unchanged.
3.2 a.  If the auto plant were worth $14 billion, the equity in the firm would be worth $14 −
$4 = $10 billion. With 100 million shares outstanding, each share would be worth $100.
b. If the outstanding stock were worth $8 billion, we would infer that the market values the
auto plant at $8 + $4 = $12 billion.
3.3 The profits for the firm are recognized in periods 2 and 3 when the sales take place. In both of
those periods, profits are $150 − $100 = $50. Cash flows are derived as follows.

Period: 1 2 3 4
1. Sales $ 0 $150 $150 $ 0
2. Change in accounts receivable 0 150 0 − 150
3. Cost of goods sold 0 100 100 0
4. Change in inventories 200 −100 − 100 0
5. Net cash flow [= (1) − (2) − (3) − (4)] −$200 $ 0 +$150 +$150

In period 2, half the units are sold for $150 but no cash is collected, so the entire $150 is treated
as an increase in accounts receivable. Half the $200 cost of production is recognized, and a like
amount is taken out of inventory. In period 3, the firm sells another $150 of product but collects
$150 from its previous sales, so there is no change in outstanding accounts receivable. Net cash
flow is the $150 collected in this period on the sale that occurred in period 2. In period 4, cash
flow is again $150, as the accounts receivable from the sale in period 3 are collected.
3.4 a.  An increase in inventories uses cash, reducing the firm’s net cash balance.
b. A reduction in accounts payable uses cash, reducing the firm’s net cash balance.
c. An issue of common stock is a source of cash.
d. The purchase of new equipment is a use of cash, and it reduces the firm’s net cash balance.
3.5
Firm A Firm B
EBIT 100 100
Interest 60    0
Pretax income 40 100
Tax (21% of pretax income) 8.4 21
Net income 31.6 79

Note: Figures in millions of dollars.

84 Part One Introduction

Taxes owed by firm A fall from $12.6 million (when debt was $40 million) to $8.4 million.
The reduction in taxes is 21% of the extra $20 million of interest expense. Net income does not
fall by the full $20 million of extra interest expense. It instead falls by interest expense less the
reduction in taxes, or $20 million − $4.2 million = $15.8 million.
3.6 For a single taxpayer with taxable income of $85,000, total taxes paid are
​(.10 × $9,950) + (.12 × $30,575) + (.22 × $44,475) = $14,449​
The marginal tax rate is 22%, but the average tax rate is only $14,449/85,000 = .170, or
17.0%. For the married taxpayers filing jointly with taxable income of $85,000, total taxes
paid are
​(.10 × $19,900) + (.12 × $61,150) + (.22 × $3,950) = $10,197​
The marginal tax rate is 22%, and the average tax rate is 10,197/85,000 = .120, or 12.0%.