Chapter 2, Problem 1Q

Define each of the following terms:

1. a. Annual report; balance sheet; income statement
2. b. Common stockholders’ equity, or net worth; retained earnings
3. c. Statement of stockholders’ equity; statement of cash flows
4. d. Depreciation; amortization; EBITDA
5. e. Operating current assets; operating current liabilities; net operating working capital; total net operating capital
6. f. Accounting profit; net cash flow; NOPAT; free cash flow; return on invested capital
7. g. Market Value Added; Economic Value Added
8. h. Progressive tax; taxable income; marginal and average tax rates
9. i. Capital gain or loss; tax loss carryforward
10. j. Improper accumulation; S corporation

Summary Introduction

To determine: The definition of annual report, balance sheet and income statement.

Explanation of Solution

The annual report is a report given annually to its investors by a corporation. This provides basic financial statements, as well as the opinion of management on the activities of the past year and the future prospects of the company. The balance sheet of a company is a statement of the financial position of the company at a specific time point. It lists the assets of the firm specifically on the left side of the balance sheet, while the right side shows its liabilities and equity or claims against those assets.

An income statement is a report that outlines the income and expenses of the company over an accounting period. At the beginning of each report, net sales are shown, after which various expenses, including income taxes, are subtracted in order to obtain the net income available to common stockholders. Reports earnings and dividends per share from the bottom of the statement.

Summary Introduction

To determine: The definition of common stockholder’s equity or net worth and retained earnings.

Explanation of Solution

Common Stockholders ' Equity (Net Worth) is the equity of public stockholders — capital stock, paid-in assets, retained earnings, and sometimes some reserves. The difference between the selling value of the stock and what stockholders pay when they bought newly issued stocks was paid-in capital. Retained earnings are the percentage of the company's profits that are held instead of dividends paid out.

Summary Introduction

To determine: The definition of statement of stock holders’ equity, statement of cash flows.

Explanation of Solution

The stockholders ' equity statement shows how much of the company's earnings have been retained in the business instead of being paid out in dividends. It also shows the resulting balance of the retained income account and the equity account of the stockholders. Note that retained earnings, not property per se, reflect a statement against capital.

Companies mostly maintain earnings to expand their business, not to collect cash on a bank account. The cash flow statement documents the effect on cash flows over an accounting period of the operating, spending and funding operations of a company.

Summary Introduction

To determine: The definition of depreciation, amortization and EBITDA.

Explanation of Solution

Depreciation of tangible assets, such as structures or equipment, is a non-cash charge. It is taken to show the estimated cost of capital equipment used up in the production process for an asset. Amortization is a non-cash cost on intangible assets, such as goodwill. EBITDA is earnings before interest, taxes, depreciation, and amortization.

Summary Introduction

To determine: The definition of operating current assets, operating current liabilities, net operating working capital and total net operating capital.

Explanation of Solution

Operating current assets are the current assets utilized to fund activities such as money, receivable accounts, and stock. It does not include savings in the short term. Current operating liabilities are the current liabilities which are a natural consequence of the operations of the firm, such as payable accounts and accruals. It does not include unpaid bills or any other short-term debt charging interest.

Net operating working capital is operating current assets minus operating current liabilities. Total net operating capital is the sum of net operating working capital and long-term assets, such as net plant and equipment. Operating capital is also equilavent to the net capital raised by investors. This is the amount of interest-bearing debt plus preferred shares plus common shares minus short-term investments.

Summary Introduction

To determine: The definition of accounting profit, net cash flow, NOPAT, free cash flow and return on invested capital.

Explanation of Solution

Accounting profit is the net income of a company as reported on its statement of income. Net cash flow is the sum of net income plus non-cash adjustments, as opposed to accounting net income. NOPAT is the amount of profit that a corporation would earn if it had no debt and no financial assets.

Free cash flow is the cash flow actually available for sale to investors after all investments in fixed assets and working capital needed to sustain ongoing operations have been made by the company. Return on capital invested is equivalent to NOPAT divided by total net operating capital. It shows the rate of return generated by assets.

Summary Introduction

To determine: The definition of market value added and economic value added.

Explanation of Solution

Market value added is the difference between the company's market value (i.e., the amount of the common equity market value, the debt market value, and preferred stock market value) and the combined equity, debt, and preferred stock book value of the company. If the book values of debt and preferred stock are equal to their market values, then MVA is equivalent to the difference between the equity market price and the amount of equity capital given by investors.

Economic value added reflects the residual income that remains after it has been removed from the price of all assets, including equity capital.

Summary Introduction

To determine: The definition of progressive tax, taxable income, marginal and average tax rates.

Explanation of Solution

A progressive tax denotes the higher one's income, the greater the amount of taxes paid. Taxable income is characterized as gross income minus a collection of exemptions and deductions that must be claimed by persons in the directions on the tax forms. The marginal tax rate for the last unit of income is defined as the tax rate. By taking the total amount of tax paid divided by taxable income, the average tax rate is calculated.

Summary Introduction

To determine: The definition of capital gain or loss, tax loss carryforward.

Explanation of Solution

Capital gain (loss) is the profit (loss) of a capital asset being sold for more (less) than its purchase price. For indefinitely and used to offset future taxable income, ordinary corporate operating losses can be carried back for 2 years.

Summary Introduction

To determine: The definition of improper accumulation, S corporation.

Explanation of Solution

Improper accumulation is a business ' retention of earnings to allow stockholders to escape dividend taxes on personal income. An S Corporation is a small corporation that elects to be taxed as a proprietorship or partnership under Subchapter S of the Internal Revenue Code but retains limited liability and another corporate form of organization benefits.