Total owners' equity question

[S2000magician]

@Phoeniyx

@S2000magician

Nope.

If you debit cash, then you received cash. Here, you haven’t.

There’s an analogy here:

When you owed wages to an employee but didn’t pay them you credited Wages Payable (a liability) and debited Wage Expense (an expense)

When you owe taxes but don’t pay them you debit Deferred Tax Liability (a liability) and credit . . . what?

“Tax Expense” or “Provision for taxes” in the Income statement? For example, lets say the Tax Expense in the Income statement is $20K. If the company has paid 14K of this already this year, WILL pay another 1K in the current operating cycle, and has DEFERRED another 5K, the entries will be as follows:

• Income Statement will show a 20K “tax expense”

• Balance sheet will show a 1K “taxes payable”

• Balance sheet will show a 5K "deferred taxes’

• The cash account will be reduced (credited) by 14K - but it’s not shown on the balance sheet as a separate entry. This is however shown on the Cash Flow statement as “cash taxes”.

All correct: in particular, the deferred taxes shows up in tax expense (which is higher), thus reducing net income.

Final questions (I hope!): Do you reduce Owner’s Equity by the amount in Deferred Taxes (i.e., do you use $1,664,000, or ($1,664,000 – $86,000))? Why or why not?

@Phoeniyx

Furthermore, please let me know if the points below are accurate as it reflects my current understanding:

• the difference in net equity (assets - liabilities) that is reflected between year 1 and year 2 of the Balance Sheet is completely explained by the Income Statement. The net income from the Income Statement should completely account for any differences in total equity between the two years on the Balance Sheet.

Not quite.

Equity = Preferred Stock (at par) + Common Stock (at par) + Other Contributed Capital + Retained Earnings + Other Comprehensive Income – Treasury Stock (+ Minority Interest)

So, Equity can change if any of these things happen:

• If the company issues new Preferred Stock: Equity will increase
• If the company issues new Common Stock: Equity will increase
• If the company has Other Comprehensive Income (e.g., a unrealized gain or loss on Available-For-Sale Securities (which doesn’t go through the income statement)): Equity will change (could go up or down)
• If the company repurchases its own stock on the open market, increasing Treasury Stock: Equity will decrease
• (Let’s ignore Minority Interest)
• If Retained Earnings changes: Equity will change (could go up or down; up is more likely)

What causes Retained Earnings to change?

• Net Income is added to Retained Earnings
• Dividends Declared are subtracted from Retained Earnings

In short, lots of things other than Net Income can change Equity.

@Phoeniyx

• The Cash Flow statement obviously explains the actual cash flow of the company. Related to the other statements, it ignores all the deferred payments, differed receivables, depreciations, and other non-cash adjustments and completely explains the “cash difference” between year 1 and year 2 of the Balance Sheet.

That’s correct.

@Phoeniyx

While we are on topic about these statements, I have another question which is confusing me a bit related to Free Cash Flow:

One of the formulas provided is: FCFF = CFO + [Interest x (1 - tax rate)] - FCInv

CFO = cash flow from operations, Interest = interest expense, FCInv = fixed capital investment

Now in this FCFF formula, we don’t substract any “working capital investment” (WCI). Substantially, this makes sense. [WCI = current assets - current liabilities]. In calculating CFO from net income (indirect method), we add liabilities (e.g. wages payable) and subtract non cash assets (e.g. accounts receivable). Therefore, many components of WCI is already subtracted from net income to get CFO - subtracting WCI again will be double counting for many items.

However, what about the “cash” aspect of working capital investment? Lets say that current assets is largely “cash” due to the company expecting some unforeseen circumstances. Therefore, WCI is largely made up of this stockpile of cash. This cash asset will NOT be subtracted from net income in calculating CFO (unlike accounts receivable) - since it’s cash. However, we want to retain this amount in the company without distributing it out based on the FCFF calculation. e.g. the management feels that it is absolutely necessary to keep $1M on hand for something crazy that might happen, but in calculating CFO from net income using the indirect method, this cash is not subtracted. However, it needs to be subtracted before calculating FCFF since we DON’T want to distribute it and want to retain it. How can this be accomodated in the above FCFF formula?

I’d encourage you to put these in a separate thread, so that this thread doesn’t lose its focus.

@Phoeniyx

As always, many thanks!

Happy to be of help.

[Phoeniyx]

@S2000magician

All correct: in particular, the deferred taxes shows up in tax expense (which is higher), thus reducing net income.

Final questions (I hope!): Do you reduce Owner’s Equity by the amount in Deferred Taxes (i.e., do you use $1,664,000, or ($1,664,000 – $86,000))? Why or why not?

You wouldn’t deduct it again. That would amount to double counting. The reason is that retained earnings is an element of Owner’s equity and net income is already a part of retained earnings. Also pursuant to the income statement, the total provision for taxes (which includes deferred) is already deducted from net income!

@S2000magician

Not quite.

Equity = Preferred Stock (at par) + Common Stock (at par) + Other Contributed Capital + Retained Earnings + Other Comprehensive Income – Treasury Stock (+ Minority Interest)

So, Equity can change if any of these things happen:

• If the company issues new Preferred Stock: Equity will increase
• If the company issues new Common Stock: Equity will increase
• If the company has Other Comprehensive Income (e.g., a unrealized gain or loss on Available-For-Sale Securities (which doesn’t go through the income statement)): Equity will change (could go up or down)
• If the company repurchases its own stock on the open market, increasing Treasury Stock: Equity will decrease
• (Let’s ignore Minority Interest)
• If Retained Earnings changes: Equity will change (could go up or down; up is more likely)

What causes Retained Earnings to change?

• Net Income is added to Retained Earnings
• Dividends Declared are subtracted from Retained Earnings

In short, lots of things other than Net Income can change Equity.

Thanks - that makes sense.

@S2000magician

I’d encourage you to put these in a separate thread, so that this thread doesn’t lose its focus.

Will do. Thanks very much S2000magician!

EDIT: I posted the other question in the thread below:

http://www.analystforum.com/forums/cfa-forums/cfa-level-i-forum/91324939

[S2000magician]

@Phoeniyx

@S2000magician

All correct: in particular, the deferred taxes shows up in tax expense (which is higher), thus reducing net income.

Final questions (I hope!): Do you reduce Owner’s Equity by the amount in Deferred Taxes (i.e., do you use $1,664,000, or ($1,664,000 – $86,000))? Why or why not?

You wouldn’t deduct it again. That would amount to double counting. The reason is that retained earnings is an element of Owner’s equity and net income is already a part of retained earnings. Also pursuant to the income statement, the total provision for taxes (which includes deferred) is already deducted from net income!

Yes, yes, yes, yes, yes!

Good job!

@Phoeniyx

@S2000magician

Equity = Preferred Stock (at par) + Common Stock (at par) + Other Contributed Capital + Retained Earnings + Other Comprehensive Income – Treasury Stock (+ Minority Interest)

So, Equity can change if any of these things happen:

• If the company issues new Preferred Stock: Equity will increase
• If the company issues new Common Stock: Equity will increase
• If the company has Other Comprehensive Income (e.g., a unrealized gain or loss on Available-For-Sale Securities (which doesn’t go through the income statement)): Equity will change (could go up or down)
• If the company repurchases its own stock on the open market, increasing Treasury Stock: Equity will decrease
• (Let’s ignore Minority Interest)
• If Retained Earnings changes: Equity will change (could go up or down; up is more likely)

What causes Retained Earnings to change?

• Net Income is added to Retained Earnings
• Dividends Declared are subtracted from Retained Earnings

In short, lots of things other than Net Income can change Equity.

Thanks - that makes sense.

Whew!

(I love those rare occasions when something I write makes sense.)

@Phoeniyx

@S2000magician

I’d encourage you to put these in a separate thread, so that this thread doesn’t lose its focus.

Will do. Thanks very much S2000magician!

My pleasure.

@Phoeniyx

EDIT: I posted the other question in the thread below:

http://www.analystforum.com/forums/cfa-forums/cfa-level-i-forum/91324939

I’ll look at that later today. Right now, I need to go running with my horse.

[Phoeniyx]

@S2000magician

I’ll look at that later today. Right now, I need to go running with my horse.

Thanks S2000magician. Hope it was a good run!

[S2000magician]

A little hot outside, but good otherwise.

I’m working too much these days, so it’s hard to find time to ride the horse, run with the horse, and run with the dog, especially when it’s close to 100° out; I have to do it early in the morning or the opportunity’s shot.