CH 03

Fundamentals of Corporate Finance
Fifth Edition, International Adaptation

Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.;
Thomas W. Bates, Ph.D.; Stuart Gillan, Ph.D.
Chapter 3
Financial Statements, Cash Flows, and

Taxes
Copyright ©2022 John Wiley & Sons, Inc.
Chapter 3: Financial Statements,
Cash Flows, and Taxes
Copyright ©2022 John Wiley & Sons, Inc. 2

Learning Objectives (1 of 2)
1. Discuss generally accepted accounting principles

(GAAP) and their importance to the economy
2. Explain the balance sheet identity and why a
balance sheet must balance
3. Describe how market-value balance sheets differ
from book-value balance sheets
4. Identify the basic equation for the income
statement and the information it provides

Learning Objectives (2 of 2)
5. Understand the calculation of cash flows from

operating, investing, and financing activities required
in the statement of cash flows
6. Explain how the four major financial statements
discussed in this chapter are related
7. Understand that differences exist in the way financial
statements are reported between countries
8. Discuss the difference between average and marginal
tax rates

3.1 Financial Statements and Accounting Principles
LEARNING OBJECTIVE
Discuss generally accepted accounting principles (GAAP) and
their importance to the economy
• Financial Statements and Accounting Principles
• The Annual Report
• Generally Accepted Accounting Principles
• Fundamental Accounting Principles
• International GAAP
• Illustrative Company: Diaz Manufacturing
L.O. 3.1 Copyright ©2022 John Wiley & Sons, Inc. 5

Financial Statements and Accounting
Principles
• In order to interpret and analyze financial statements,
we need to understand some accounting principles that
guide their preparation
• This chapter discusses generally accepted accounting
principles (GAAP)
• Principles of GAAP guide firms in the preparation of
financial statements

Annual Report
• The annual report is the most important report that firms

issue to their stockholders and the public
• Summarizes the overall performance of a firm for the most
recent fiscal year
o Tables containing financial information and operations
o Information on the firm’s products, services, and
contributions
o Audited financial statements: balance sheet, income
statement, statement of retained earnings, and the
statement of cash flows
Generally Accepted Accounting
Principles (GAAP)
o Accounting rules and standards that public companies must
adhere to when they prepare financial statements and reports
o Established by the Financial Accounting Standards Board (FASB)
and authorized by the Securities and Exchange Commission
(SEC)
o Standards make it easier for analysts and management to make
meaningful comparisons of company performance
• (GAAP) are guidelines, not rules
o Firms have discretion about how their financial information is
presented
o Practical application requires professional judgement

Fundamental Accounting Principles
(1 of 2)
• The Assumption of arm’s length transaction
o Parties involved in an economic transaction arrive at a
decision independently and rationally
• The cost principle
o Asset values are recorded at the cost for which they
were acquired (and must be adjusted if they fall in
value)
o Investors want current prices and prefer a market value
balance sheet (finance) versus a book value balance
sheet (accounting)
Fundamental Accounting Principles
(2 of 2)
• Realization Principle
o Revenue is recognized when a transaction is completed,
although cash may be received earlier or later
• Matching Principle
o Revenue is matched with the expense incurred to
generate the revenue
• Going Concern Assumption
o Assumption that a company will continue to operate for
the foreseeable future
International GAAP
• Uniform accounting rules and procedures promoted by

the International Accounting Standards Board
• Economic and political pressure is building in the

United States and Europe to develop a unified
accounting system

Illustrative Company: Diaz
Manufacturing
• In 2020 Diaz Manufacturing’s sales were $1.56 billion,
an increase of 12.8 percent from the previous year
• A letter to stockholders in the 2020 annual report stated
that management did not expect earnings in 2021 to
exceed the 2020 earnings
• Management reassured investors, however, that Diaz
had the financial strength and the management team
needed to weather any economic adversity

3.2 The Balance Sheet
LEARNING OBJECTIVE
Explain the balance sheet identity and why a balance
sheet must balance
• The Balance Sheet
• Current Assets and Liabilities
• Long-Term Assets and Liabilities
• Equity

The Balance Sheet (1 of 2)
• A balance sheet is a financial statement that shows a

firm’s financial position (assets, liabilities, and equity)
at a point in time
• The basic balance sheet identity can be stated as
Equation 3.1
o Total assets = Total liabilities + Total stockholders’
equity

The Balance Sheet (2 of 2)
• Total Assets
o The left side of a balance sheet shows assets a firm owns
and uses to generate revenue
o Assets are listed in order of liquidity
• Sources of Funds
o The right side of the balance sheet show the sources of the
funds used to acquire assets
o Liabilities are listed in the order in which they are due to be
paid
o Stockholders’ equity is listed last
• Common stockholders are entitled to assets remaining after all
other providers of funds are paid
Exhibit 3.1. Diaz Manufacturing Balance
Sheets as of December 31 ($ millions) (1 of 2)
Assets 2020 2019
Casha $ 288.5 $ 16.6
Accounts receivable 306.2 268.8
Inventories 423.8 372.7
Other current assets 21.3 29.9
Total current assets $1,039.8 $ 688.0
Plant and equipment 911.6 823.3
Less: Accumulated depreciation 512.2 429.1
Net plant and equipment $ 399.4 $ 394.2
Goodwill and other assets 450.0 411.6
Total assets $1,889.2 $1,493.8
a
Cash includes investments in marketable securities.

Exhibit 3.1. Diaz Manufacturing Balance
Sheets as of December 31 ($ millions) (2 of 2)
Liabilities and Stockholders’ Equity 2020 2019
Accounts payable and accruals $ 349.3 $ 325.0
Notes payable 10.5 4.2
Accrued taxes 18.0 16.8
Total current liabilities $ 377.80 $ 346.0
Long-term debt 574.0 305.6
Total liabilities $ 951.80 $ 651.6
Preferred stockb – –
Common stock (54,566,054 shares)c 50.0 50.0
Additional paid-in capital 842.9 842.9
Retained earning 67.8 (50.7)
Treasury stock (571,320 shares) (23.3) –
Total stockholders' equity $ 937.4 $ 842.2
Total liabilities and equity $1,889.2 $1,493.8
b
10,000,000 preferred stock shares authorized.
c
150,000,000 common stock shares authorized.

Current Assets and Liabilities
• Current assets are those likely to be converted to cash
within a year (or one operating cycle)
o Marketable securities
o Accounts receivable
o Inventory
o Current liabilities are those scheduled to be paid within a
year (or one operating cycle)
o Accounts payable
o Accrued wages
o Debt with less than a year’s maturity
o Taxes
Net Working Capital
Equation 3.2
Net Working Capital = Total Current Assets − Total Current

Liabilities

Net Working Capital Example
• Diaz Manufacturing
o Total current assets = $1,039.8 million
o Total current liabilities = $377.8 million
o Net working capital = Total current assets − Total
current liabilities
= $1,039.8 million − $377.8 million
= $662.0 million
o Diaz’s NWC is good; from a bank’s perspective, Diaz
should have enough current assets to pay off all current
liabilities.
Accounting for Inventory
• Inventory is the least liquid current asset

• Inventory is reported using one of two methods
o FIFO (first-in-first-out) assumes merchandise is sold in
the order it was acquired by the firm
o LIFO (last-in-first-out) assumes merchandise is sold in
the reverse of the order it was acquired by a firm

FIFO versus LIFO Methods
• When the cost of inventory is increasing FIFO reporting shows
the firm sold the less expensive inventory, which leads to
o Higher balance in inventory
o Lower cost-of-goods-sold
o Higher taxable income, income taxes, and net income
• When the cost of inventory is increasing LIFO reporting shows
the firm sold the more expensive inventory, which leads to
o Lower balance in inventory
o Higher cost-of-goods sold
o Lower taxable income, income taxes, and net income

Other Issues on Accounting for
Inventory
• A majority of corporations value inventory using LIFO
because it yield the lowest taxable income and
therefore lower taxes
• Firms may switch from one inventory accounting
method to the other under extraordinary circumstances
but not frequently

Long-Term Assets
• Real assets
o Land
o Buildings
o Equipment
o Intangible assets
o Goodwill
o Patents
o Copyrights

Long-Term Liabilities
Long-term Liabilities or long-term debt include

o Bank loans
o Mortgages
o Bonds with maturity longer than one year

The Common Stock Accounts
• Common Stock
o Ownership with control in a firm
• Basic rights of ownership
o The right to vote on corporate matters
o The preemptive right to purchase additional shares
proportionally when new shares are issued by the
company
o The right to receive cash dividends if they are paid
o The right to corporate assets if the firm is liquidated,
after all creditors and preferred stockholders
Other Forms of Equity
• Retained earnings
o Profit kept and used to acquire assets.
• Treasury stock
o Shares of its own stock a firm holds rather than sell them to
the public
• The firm doesn’t pay dividends on those shares
• More control over voting
• Can buy when firm believes stock is undervalued
•Preferred Stock
o Ownership without control in a firm
o Features make it an equity security that resembles debt
3.3 Market Value versus Book Value
LEARNING OBJECTIVE
Describe how market-value balance sheets differ from book-value
balance sheets
• Market Value versus Book Value

• A More Informative Balance Sheet
• A Market-Value Balance Sheet

Market Value versus Book Value
• Asset Value is usually reported at historical cost or

book value as opposed to its true value or market value
• Accounting statements would be more valuable if they
measured current value. The process of recording
assets at their current market value is often called
marking to market
• On the downside, it can be difficult to identify the
market value of an asset, particularly if there are few
transactions involving comparable assets

A More Informative Balance Sheet
• Assets
o Assets are traditionally reported at historical cost on a balance sheet
o Balance sheet amount does not reflect current market value, only the
acquisition cost
o Liabilities
o Balance sheet shows the amount the company is required to pay which
is generally close to the actual market value for short-term liabilities
because of their relatively short maturities.
o For long-term debt, however, book value and market value can differ
substantially
o Stockholders’ Equity
o The difference between the market values of assets and liabilities
provides a better estimate of the value of shareholders’ equity than the
book values

A Market-Value Balance Sheet
• Marvel Airline’s fleet has a book value of $600 million
• As a result of COVID-19 the market value of Marvel’s
aircraft fleet is only $400 million
• Using these data, we can construct two balance sheets, one
based on historical book values and the other based on
market values

3.4 The Income Statement and the Statement of Retained Earnings
LEARNING OBJECTIVE
Identify the basic equation for the income statement and the
information it provides
• The Income Statement and the Statement of Retained

Earnings
• The Income Statement
• The Statement of Retained Earnings

The Income Statement and the
Statement of Retained Earnings
• The income statement
o Summarizes the revenues, expenses, and profitability
(or losses) of the firm over some period of time, usually
a month, a quarter, or a year.
• The statement of retained earnings

o Affected by when the firm reports net income or loss,
and when the board of directors declares and pays a
cash dividend

The Income Statement
• Measures the profitability of a firm for a reporting

period
• Revenue is income from selling products and services
• Expenses include costs of providing products and
services, and asset utilization (depreciation and
amortization)
Equation 3.3
Net income = Revenues − Expenses

Diaz Manufacturing Income Statements for
the Fiscal Year Ending December 31 ($ millions)
Exhibit 3.2 The income statement shows the sales, expenses, and profit earned by the firm
over a specific period of time.
2020 2019
Net sales a $1,563.7 $1,386.7
Cost of goods sold 1,081.1 974.8
Selling and administrative expenses 231.1 197.4
Earnings before interest, taxes, depreciation, and amortization
$ 251.5 $ 214.5
(EBITDA)
Depreciation and amortization 83.1 75.3
Earnings before interest and taxes (EBIT) $ 168.4 $ 139.2
Interest expense 5.6 18.0
Earnings before taxes (EBT) $ 162.8 $ 121.2
Taxes 44.3 16.1
Net income $118.50 $105.10

Diaz Manufacturing: Changes to Retained
Earnings for the Fiscal Year Ending December 31 ($ millions)
2020 2019
Common stock dividend — —
Addition to retained earnings $ 118.5 $ 105.1
Per-share data:
Common stock price
Earnings per share (EPS) $ 2.17 $ 1.93
Dividends per share (DPS) — —
Book value per share (BVPS) — —
a
Cashincludes
Cash flow per share (CFPS)
investments $
in marketable securities. 3.69 $ 3.31
Net Income Example
Using Equation 3.3

• Diaz Manufacturing
o Revenues = $1,563.7 million
o Expenses = $1,445.2 million
o Net Income = Revenues − Expenses
= $1,563.7 million − $1,445.2 million
= $ 118.5 million

Depreciation Expense
• The cost of a physical asset such as plant or machinery

is written off over its lifetime. This is called
depreciation, which is a non-cash expense
• Firms use one of these depreciation methods
o Straight-line depreciation
o Accelerated depreciation
• Firms may choose one method for internal purposes
and another for tax purposes or for statements released
to the public
Amortization Expense
• Amortization expense is related to using intangible

assets
o Goodwill
o Patents
o Licenses
• Like depreciation, amortization is a non-cash expense

Extraordinary Items
• Income or expense associated with events that are

infrequent and abnormal
o Separated from the results of ordinary income
o Shown separately on the income statement

Step by Step to the Bottom Line
• Earnings-before-interest-taxes-depreciation-and-
amortization (EBITDA)
o Income from selling goods and services minus the cost of
providing them
•Earnings-before-interest-and-taxes (EBIT)
o EBITDA minus depreciation and amortization
•Earnings-before-taxes (EBT)
o EBIT minus interest expense
o Taxable income
•Net income (NI)
o EBT minus taxes
The Statement of Retained Earnings
The statement of retained earnings accompanies the balance sheet and shows the
beginning balance of retained earnings, the adjustments made to retained
earnings during the year, and the ending balance.
Exhibit 3.3 Diaz Manufacturing Statement of Retained

Earnings for the Fiscal Year Ending December 31, 2020 ($
millions)
Balance of retained earnings, December 31, 2019 ($50.7)
Add: Net income, 2020 118.5
Less: Dividends to common stockholders, 2020 ____

Balance of retained earnings, December 31, 2020 $67.8

3.5 The Statement of Cash Flows
LEARNING OBJECTIVE
Understand the calculations of cash flows from operating, investing, and
financing activities required in the statement of cash flows
• The Statement of Cash Flows

• Sources and Uses of Cash

The Statement of Cash Flows
• Net cash flow is equal to cash inflows minus cash
outflows
• The statement of cash flows shows the company’s cash
inflows and outflows for a period of time
o Working capital
o Fixed assets
o Long-term liabilities and equity
o Dividends

Sources and Uses of Cash
• The statement of cash flows shows the company’s
cash inflows (receipts) and cash outflows (payments
and investments) for a period of time.
• Changes in balance sheet accounts reflect cash flows
o Sources of cash
• Decreases in assets
• Increases in liabilities and equity
o Uses of cash
• Increases in assets
• Decreases in liabilities and equity
Organization of the Statement of Cash
Flows
• Operating Activities
o Cash inflows from selling goods and services
o Cash outflows from raw materials, inventory, salaries/wages, utilities,
rent
• Long-Term Investing Activities
o Cash inflows and outflows from
• Buying and selling long-term assets such as plant and equipment
• Buying and selling bonds and stocks issued by other firms
• Financing Activities
o Cash inflows from issuing debt and equity, borrowing money
o Cash outflows from paying interest or dividends, repaying loan
principal, and purchasing Treasury stock
• Cash Reconciliation
Diaz Manufacturing Statement of Cash
Flows: Operating Activities for the Fiscal Year Ending
December 31, 2020 ($ millions)
Exhibit 3.4 The statement of cash flows shows the sources of the cash that has come into
the firm during a period of time and the ways in which this cash has been used.
Operating Activities
Net income $ 118.5
Additions (sources of cash)
Depreciation and amortization 83.1
Increase in accounts payable 24.3
Decrease in other current assets 8.6
Increase in accrued income taxes 1.2
Subtractions (uses of cash)
Increase in accounts receivable (37.4)
Increase in inventories (51.1)
Net cash provided by operating activities $ 147.2

Flows: Long-Term Investing and Financing Activities for the
Fiscal Year Ending December 31, 2020 ($ millions)
Long-Term Investing Activities
Property, equipment, and other assets $ (88.3)
Increase in goodwill and other assets (38.4)
Net cash used in investing activities $(126.7)
Financing Activities
Increase in long-term debt $ 268.4
Purchase of treasury stock (23.3)
Increase in notes payable 6.3
Net cash provided by financing $ 251.4
activities
Flows: Cash Reconciliation for the Fiscal Year Ending
December 31, 2020 ($ millions)
Cash Reconciliationa
Net increase in cash and marketable $ 271.9

securities
Cash and securities at beginning of 16.6

year
Cash and securities at end of year $ 288.5
a
Cash includes investments in marketable securities.
3.6 Tying Together the Financial Statements
LEARNING OBJECTIVE
Explain how the four major financial statements discussed in this
chapter are related
• Tying Together the Financial Statements

Tying Together the Financial
Statements
• The balance sheet summarizes what assets the firm has
and how the firm has financed those assets with debt
and equity
• The statement of cash flows is a summary of the

changes in a firm’s balance sheet from the beginning of
a period to the end of that period

The Interrelations among the Financial Statements: Illustrated
Using Diaz Manufacturing Financial Results ($ millions)
Exhibit 3.5 The statement of cash flows ties together the income statement with the balance sheets
from the beginning and the end of the period. The statement of retained earnings shows how the
retained earnings account has changed from the beginning to the end of the period.

3.7 International Accounting Issues
LEARNING OBJECTIVE
Understand that differences exist in the way financial statements
are reported between countries.
• Information, Timeliness, and Language

• Foreign Currency Issues
• Differences in Presentation and Accounting Standards
• Differences in the Business Environment

IFRS as a Global Standard
• The move to IFRS as a global standard has reduced

many difficulties of analyzing financial statements in
different countries, but differences and difficulties
remain. These mainly relate to what is being disclosed,
differences in presentation, reports presented in foreign
currencies, and differences in the business
environment.

IFRS as a Global Standard
• In particular, high rates of inflation in a particular

country require a different approach to the presentation
of financial statements to reflect the loss of purchasing
power over time.

3.8 Corporate Income Tax
LEARNING OBJECTIVE
Discuss the difference between average and marginal tax rates
• Corporate Income Tax Rates

• Average versus Marginal Tax Rates
• Unequal Treatment of Dividends and Interest Payments

Corporate Income Tax Rates
• In 2017 the Tax Cuts and Jobs Act introduced major
changes to the federal tax code
• One of the most significant changes for corporations
(C-Corps) was the introduction of a single or “flat” tax
rate of 21 percent on taxable income
• In 2018 this new flat tax replaced the previous
progressive income tax rate, under which higher levels
of income were progressively taxed at higher rates

Average versus Marginal Tax Rates
• Average tax rate is total taxes paid, divided by taxable
income for the period
• Marginal tax rate is the rate paid on the last dollar
earned or the next dollar that will be earned

Unequal Treatment of Dividends &
Interest
• Dividends and interest are not equal
o The U.S. tax code allows interest payments on debt to
reduce firms’ taxable income
o The tax code does not allow dividend payments to
equity to reduce firms’ taxable income
o Therefore, debt financing has a lower cost relative to
equity financing

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Copyright © 2022 John Wiley & Sons, Inc.

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Fundamentals of Corporate Finance

Fifth Edition, International Adaptation

Financial Statements, Cash Flows, and

Copyright ©2022 John Wiley & Sons, Inc. 2

1. Discuss generally accepted accounting principles

Copyright ©2022 John Wiley & Sons, Inc. 3

5. Understand the calculation of cash flows from

Copyright ©2022 John Wiley & Sons, Inc. 4

L.O. 3.1 Copyright ©2022 John Wiley & Sons, Inc. 5

L.O. 3.1 Copyright ©2022 John Wiley & Sons, Inc. 6

• The annual report is the most important report that firms

L.O. 3.1 Copyright ©2022 John Wiley & Sons, Inc. 8

• Uniform accounting rules and procedures promoted by

• Economic and political pressure is building in the

L.O. 3.1 Copyright ©2022 John Wiley & Sons, Inc. 11

L.O. 3.1 Copyright ©2022 John Wiley & Sons, Inc. 12

L.O. 3.2 Copyright ©2022 John Wiley & Sons, Inc. 13

• A balance sheet is a financial statement that shows a

L.O. 3.2 Copyright ©2022 John Wiley & Sons, Inc. 14

L.O. 3.2 Copyright ©2022 John Wiley & Sons, Inc. 16

L.O. 3.2 Copyright ©2022 John Wiley & Sons, Inc. 17

Net Working Capital = Total Current Assets − Total Current

L.O. 3.2 Copyright ©2022 John Wiley & Sons, Inc. 19

• Inventory is the least liquid current asset

L.O. 3.2 Copyright ©2022 John Wiley & Sons, Inc. 21

L.O. 3.2 Copyright ©2022 John Wiley & Sons, Inc. 22

L.O. 3.2 Copyright ©2022 John Wiley & Sons, Inc. 23

L.O. 3.2 Copyright ©2022 John Wiley & Sons, Inc. 24

Long-term Liabilities or long-term debt include

L.O. 3.2 Copyright ©2022 John Wiley & Sons, Inc. 25

• Market Value versus Book Value

L.O. 3.3 Copyright ©2022 John Wiley & Sons, Inc. 28

• Asset Value is usually reported at historical cost or

L.O. 3.3 Copyright ©2022 John Wiley & Sons, Inc. 29

L.O. 3.3 Copyright ©2022 John Wiley & Sons, Inc. 30

L.O. 3.3 Copyright ©2022 John Wiley & Sons, Inc. 31

• The Income Statement and the Statement of Retained

L.O. 3.4 Copyright ©2022 John Wiley & Sons, Inc. 32

• The statement of retained earnings

L.O. 3.4 Copyright ©2022 John Wiley & Sons, Inc. 33

• Measures the profitability of a firm for a reporting

L.O. 3.4 Copyright ©2022 John Wiley & Sons, Inc. 34

L.O. 3.4 Copyright ©2022 John Wiley & Sons, Inc. 35

Common stock dividend — —

Addition to retained earnings $ 118.5 $ 105.1

Common stock price

Earnings per share (EPS) $ 2.17 $ 1.93

Dividends per share (DPS) — —

Book value per share (BVPS) — —

Using Equation 3.3

L.O. 3.4 Copyright ©2022 John Wiley & Sons, Inc. 37

• The cost of a physical asset such as plant or machinery

• Amortization expense is related to using intangible

• Like depreciation, amortization is a non-cash expense

L.O. 3.4 Copyright ©2022 John Wiley & Sons, Inc. 39

• Income or expense associated with events that are

L.O. 3.4 Copyright ©2022 John Wiley & Sons, Inc. 40

Exhibit 3.3 Diaz Manufacturing Statement of Retained

Balance of retained earnings, December 31, 2019 ($50.7)

Add: Net income, 2020 118.5

Less: Dividends to common stockholders, 2020 ____

L.O. 3.4 Copyright ©2022 John Wiley & Sons, Inc. 42

• The Statement of Cash Flows