400 Question Flashcards - Accounting
Walk me through the 3 financial statements.
- The 3 major financial statements are the Income Statement (I/S)‚ Balance Sheet (B/S) and the Cash Flow Statement (SCF).
- The I/S shows the company’s revenue and expenses over a period of time‚ and goes down to Net Income (NI)‚ the final line on the statement.
- The B/S shows the company’s Assets (its resources - such as Cash‚ Inventory‚ and PP&E) as well as its Liabilities (such as Debt and Accounts Payable) and Shareholders’ Equity (SE) at a specific point in time. Assets must equal Liabilities plus SE.
- The SCF begins with NI‚ adjusts for non-cash expenses and changes in operating assets and liabilities (working capital)‚ and then shows how the company has spent or received cash from Investing or Financing activities; at the end‚ you see the company’s net change in cash.
Can you give me examples of major line items on each of the financial statements?
- INCOME STATEMENT: Revenue; Cost of Goods Sold (COGS); Selling‚ General & Administrative (SG&A) Expenses; Operating Income‚ Pre-Tax Income‚ Net Income.
- BALANCE SHEET: Cash‚ Accounts Receivable (A/R)‚ Inventory‚ Plants‚ Property & Equipment (PP&E)‚ Accounts Payable‚ Accrued Expenses‚ Debt‚ Shareholders’ Equity (SE)
- CASH FLOW STATEMENT: Cash Flow from Operations (CFO) - Net Income‚ Depreciation & Amortization (D&A)‚ Stock-Based Compensation‚ Changes in Operating Assets & Liabilities; Cash Flow from Investing (CFI) - Capital Expenditures (CapEx)‚ Sale of PP&E‚ Sale/Purchase of Investments; Cash Flow from Financing (CFF) - Dividends Issued‚ Debt Raised/Paid Off‚ Shares Issued/Repurchased
How do the 3 statements link together?
- To tie the 3 statements together‚ NI from the I/S becomes the top line of the SCF.
- Then you add back any non-cash charges such as D&A to this NI number.
- Next‚ changes to operational B/S items appear and either reduce or increase cash flow depending on whether they are Assets or Liabilities and whether they go up or down. That gets you to CFO.
- Now you take into account investing and financing activities and changes to items like PP&E and Debt on the B/S; those will increase or decrease cash flow‚ and at the bottom you get net change in cash.
- On the B/S for the end of this period‚ Cash at the top equals the beginning Cash number (from the start of this period)‚ plus the net change in cash from the SCF.
- On the other side‚ NI flows into SE to make the B/S balance.
- At the end‚ Assets must always equal Liabilities plus SE.
If I were stranded on a desert island and only had one financial statement and I wanted to review the overall health of a company‚ which statement would I use and why?
- You would use the SCF b/c it gives a true picture of how much cash the company is actually generating - the I/S is misleading b/c it includes non-cash expenses and excludes actual cash expenses such as Capital Expenditures.
- And that’s the #1 thing you care about when analyzing the financial health of any business - its true cash flow.
Let’s say I could only look at 2 statements to assess a company’s prospects - which 2 would I use and why?
You would pick the I/S and B/S because you can create the SCF from both of those (assuming that you have the “Beginning” and “Ending” Balance Sheets that correspond to the same period the I/S is tracking.
Let’s say I have a new‚ unknown item that belongs on the Balance Sheet. How can I tell whether it should be an Asset or a Liability?
- An Asset will result in additional cash or potential cash in the future - think about how Investments or A/R will result in a direct cash increase‚ and how Goodwill or PP&E may result in an indirect cash increase in the future.
- A Liability will result in less cash or potential cash in the future - think about how Debt or A/P will result in a direct cash decrease‚ and how something like Deferred Revenue will result in an indirect cash decrease as you recognize additional taxes in the future from recognizing revenue.
- Ask what direction cash will move in as a result of this new item and that tells you whether it’s an Asset or Liability.
How can you tell whether or not an expense should appear on the Income Statement?
Two conditions must be true for an expense to appear on the I/S:
1. It must correspond to something in the current period
2. It must be tax-deductible.
• Employee compensation and marketing spending‚ for example‚ satisfy both conditions.
• Depreciation and Interest Expense also meet both conditions - Depreciation only represents the “loss in value” of PP&E (or to be more technically precise‚ the allocation of the investment in PP&E) in the current period you’re in.
• Repaying debt principal does NOT satisfy both of these conditions b/c it is not tax-deductible.
• ADV. NOTE: Technically‚ “tax-deductible” here means “deductible for BOOK tax purposes” (i.e. only the tax number that appears on the company’s I/S).
Let’s say that you have a non-cash expense (Depreciation or Amortization for example) on the Income Statement. Why do you add back the entire expense on the Cash Flow Statement?
- Because you want to reflect that you’ve saved on taxes with the non-cash expense.
- Let’s say you have a non-cash expense of $10 and a tax rate of 40%. Your NI decreases by $6 as a result… but then you add back the entire non-cash expense of $10 on the SCF so that your cash goes up by $4.
- That increase of $4 reflects the tax savings from the non-cash expense. If you just added back the after-tax expense of $6 you’d be saying‚ “This non-cash expense has no impact on your taxes or cash balance.”
How do you decide when to capitalize rather than expense a purchase?
- If the purchase corresponds to an Asset with a useful life of over 1 year‚ it is capitalized (put on the B/S rather than shown as an expense on the I/S). Then it is Depreciated (tangible assets) or Amortized (intangible assets) over a certain number of years.
- Purchases like factories‚ equipment and land all last longer than a year and therefore show up on the B/S. Employee salaries and the cost of manufacturing products (COGS) only “last” for the current period and therefore show up on the I/S as normal expenses instead.
- Note that even if you’re paying for something like a multi-year lease for a building‚ you would NOT capitalize it unless you own the building and pay for the entire building in advance.
If Depreciation is a non-cash expense‚ why does it affect the cash balance?
Although Depreciation is a non-cash expense‚ it is tax-deductible. Therefore‚ an increase in Depreciation will reduce the amount of taxes you pay‚ which boosts your cash balance. The opposite happens if Depreciation decreases.
Where does Depreciation usually appear on the Income Statement?
It could be a separate line item‚ or it could be embedded in COGS or Operating Expenses - each company does it differently. Note that the end result for accounting questions is the same: Depreciation always reduced Pre-Tax Income.
Why is the Income Statement not affected by Inventory purchases?
The expense of purchasing Inventory is ONLY recorded on the I/S when the goods associated with it have been manufactured and sold - so if it’s just sitting in a warehouse‚ it does not count as Cost of Goods Sold (COGS) until the company manufactures it into a product and sells it.
Debt repayment shows up in Cash Flow from Financing on the Cash Flow Statement. Why don’t interest payments also show up there? They’re a financing activity!
- The difference is that interest payments correspond to the current period and are tax-deductible‚ so they have already appeared on the I/S. Since they are a true cash expense and already appeared on the I/S‚ showing them on the SCF would be double-counting them and would be incorrect.
- Debt repayments are a true cash-expense but they do NOT appear on the I/S‚ so we need to adjust for them on the SCF.
- If something is a true cash expense and it has already appeared on the I/S‚ it will NEVER appear on the SCF unless we are re-classifying it - b/c you have already factored in its cash impact.
What’s the difference between Accounts Payable and Accrued Expenses?
- Mechanically‚ they are the same: they’re Liabilities on the B/S used when you’ve recorded an I/S expense for a product/service you have received‚ but have not yet paid for in cash. They both affect the statements in the same way as well.
- The difference is that A/P is mostly for one-time expenses with invoices‚ such as paying for a law firm‚ whereas Accrued Expenses is for recurring expenses without invoices‚ such as employee wages‚ rents‚ and utilities.
When would a company collect cash from a customer and NOT record it as revenue?
- Typically this happens when the customer pays upfront‚ in cash‚ for months or years of a product/service‚ but the company hasn’t delivered it yet. You see this in web-based subscription software‚ cell phone carriers that sell annual contracts‚ and magazine publishers that sell subscriptions.
- You only record revenue when you actually deliver the products/services - so the company does not record cash collected as revenue right away.
If cash collected is not recorded as revenue‚ what happens to it?
- It goes into the Deferred Revenue balance on the B/S under Liabilities.
- Over time‚ as the services or products are delivered‚ the Deferred Revenue balance turns into real revenue on the I/S and the Deferred Revenue balance decreases.
Deferred Revenue reflects cash that we’ve already collected upfront for a product/service we haven’t delivered yet. Why is it a Liability? That’s great for us!
- Remember the definitions of Assets and Liabilities: an Asset results in more future cash and a Liability results in less future cash.
- Think about how Deferred Revenue works: not only is the burden on us to deliver the product/service in question‚ but we are also going to pay additional taxes and possibly recognize additional future expenses when we record it as real revenue.
- It’s counter-intuitive‚ but that is why Deferred Revenue is a liability: it implies additional future expenses.
So what’s the difference between Accounts Receivable and Deferred Revenue? They sound similar.
There are 2 main differences:
1. A/R has NOT yet been collected in cash from customers‚ whereas Deferred Revenue has been.
2. A/R is for a product/service that the company has ALREADY delivered but hasn’t been paid for yet‚ whereas Deferred Revenue is for a product/service the company has NOT yet delivered.
• A/R is an Asset b/c it implies additional future cash whereas Deferred Revenue is a Liability b/c it implies the opposite.
How long does it usually take for a company to collect its Accounts Receivable balance?
Generally the Accounts Receivable Days are in the 30-60 day range‚ though it can be higher for companies selling higher-priced items and it might be lower for companies selling lower-priced items with cash payments only.
How are Prepaid Expenses and Accounts Payable different?
It’s similar to the difference between A/R and Deferred Revenue:
- Prepaid Expenses have already been paid out in cash‚ but haven’t yet shown up on the I/S‚ whereas A/P haven’t been paid out in cash but have shown up on the I/S.
- Prepaid Expenses are for product/services that have not yet been delivered to the company‚ whereas A/P is for products/services that have already been delivered.
You’re reviewing a company’s Balance Sheet and you see an “Income Taxes Payable” line item on the Liabilities side. What is this?
- Income Taxes Payable refers to normal income taxes that accrue and are then paid out in cash‚ similar to Accrued Expenses‚ but for taxes instead.
- Example: A company pays corporate income taxes in cash once every 3 months. But they also have monthly I/S where they record income taxes‚ even if they haven’t been paid out in cash yet.
- Those taxes increase the Income Taxes Payable account until they are paid out in cash‚ at which point Income Taxes Payable decreases.
You see a “Noncontrolling Interest” (AKA Minority Interest) line item on the Liabilities side of a company’s Balance Sheet. What does this mean?
- If you own over 50% but less than 100% of another company‚ this refers to the portion you DO NOT OWN.
- Example: Another company is worth $100. You own 70% of it. Therefore‚ there will be a Noncontrolling Interest of $30 on your B/S to represent the 30% you do not own.
You see an “Investments in Equity Interest” (AKA Associate Companies) line item on the Assets side of a firm’s Balance Sheet. What does this mean?
- If you own over 20% but less than 50% of another company‚ this refers to the portion that you DO OWN.
- Example: Another company is worth $100‚ you own 25% of it. Therefore‚ there will be an “Investments in Equity Interests” line item of $25 on your B/S to represent the 25% that you own.
Could you ever negative Shareholders’ Equity? What does it mean?
Yes‚ it is common in 2 scenarios:
1. Leveraged Buyouts w/ dividend recapitalizations - it means that the owner of the company has taken out a large portion of its equity (usually in the form of cash)‚ which can sometimes turn the number negative.
2. It can also happen if the company has been losing money consistently and therefore has declining Retained Earnings balance‚ which is a portion of SE.
• It doesn’t “mean” anything in particular‚ but it might demonstrate that the company is struggling.
• NOTE: The Equity Value (AKA Market Cap) is different from SE and that Equity Value can NEVER be negative.
What is Working Capital? How is it used?
Working Capital = Current Assets - Current Liabilities
• If it’s positive‚ it means a company can pay off its short-term Liabilities with its short-term Assets. It is often presented as a financial metric and its magnitude and sign (negative or positive) tells you whether or not the company is “sound.”
• You use Operating Working Capital more commonly in finance‚ and that is defined as (Current Assets Excluding Cash & Investments) - (Current Liabilities Excluding Debt)
• The point of Operating Working Capital is to exclude items that relate to a company’s financing and investment activities - Cash‚ Investments‚ and Debt - from the calculation.
• “Changes in Working Capital” more commonly called “Changes in Operating Assets and Liabilities) also appears on the SCF in CFO and tells you how these operationally-related B/S items change over time.
“Short-Term Investments” is a Current Asset - should you count it in Working Capital?
- No. If you wanted to be technical‚ you could say that it should be included in “Working Capital‚” as define‚ but left out of “Operating Working Capital.”
- But the truth is that no one lists Short-Term Investments in this section b/c Purchases and Sales of Investments are considered investing activities‚ NOT operational activities.
- “Working Capital” is an imprecise idea and we prefer to say “Operating Assets and Liabilities” b/c that’s a more accurate way to describe the concept of operationally-related B/S items - which may sometimes be Long-Term Assets or Long-Term Liabilities (e.g. Deferred Revenue).
What does negative (Operating) Working Capital mean? Is that a bad sign?
Not necessarily. It depends on the type of company and the specific situation - here are a few different things it could mean:
- Some companies with subscriptions or longer-term contracts often have negative Working Capital b/c of high Deferred Revenue balances.
- Retail and restaurant companies like Amazon‚ Wal-Mart‚ and McDonald’s often have negative Working Capital‚ b/c customers pay upfront‚ but they wait weeks or months to pay their suppliers - this is a sign of business efficiency and means that they have a healthy cash flow.
- In other cases‚ negative Working Capital could point to financial trouble or possible bankruptcy (for example‚ when the company owes a lot of money to suppliers and cannot pay with cash on-hand).
What’s the difference between cash-based and accrual accounting?
- Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out; accrual accounting recognizes revenue when collection is reasonably certain (i.e. after an invoice has been sent to the customer and the customer has a track record of paying on time) and recognizes expenses when they are incurred rather than when they are paid out in cash.
- All large companies use accrual accounting b/c it more accurately reflects the timing of revenue and expenses; small businesses may use cash-based accounting to simplify their financial statements (you no longer need a Cash Flow Statement if everything is cash-based).
Let’s say a customer pays for a TV with a credit card. What would this look like under cash-based vs. accrual accounting?
- Under cash-based accounting‚ the revenue would not show up until the company charges the customer’s credit card‚ receives authorization‚ and deposits the funds in its bank account - at which point it would add to Revenue on the I/S (and Pre-Tax Income‚ Net Income‚ etc.) and Cash on the B/S.
- Under accrual accounting‚ it would show up as Revenue right away but instead of appearing in Cash on the B/S‚ it would go into A/R at first. Then‚ once the cash is actually deposited in the company’s bank account‚ it would move into the Cash line item and A/R would go down.
Why do companies report GAAP or IFRS earnings‚ AND non-GAAP/ non-IFRS (or “Pro-Forma”) earnings?
- Many companies have non-cash charges such as Amortization and Intangibles‚ Stock-Based Compensation‚ and Write-Downs on their Income Statements‚ all of which negatively impact their Net Income.
- Companies therefore report alternative “Pro Forma” metrics that exclude these expenses and paint a more favorable picture of their earnings‚ under the argument that these metrics better represent “true cash earnings.”
A company has had positive EBITDA for the past 10 years‚ but it recently went bankrupt. How could this happen?
There are several possibilities:
1. The company is spending too much CapEx - these are not reflected in EBITDA but represent true cash expenses‚ so CapEx alone could make the company cash flow-negative.
2. The company has high Interest Expense and is no longer able to afford its Debt.
3. The company’s Debt all matures on one date and it is unable to refinance due to a “credit crunch” - and it runs out of cash when paying back the Debt.
4. It has significant one-time charges (from litigation‚ for example) that have been excluded from EBITDA and those are high enough to bankrupt the company.
• Remember‚ EBITDA excludes investments in (and Depreciation of) Long-Term Assets‚ Interest‚ and Non-Recurring Charges - and any one of those could represent massive cash expenses.
Normally Goodwill remains constant on the Balance Sheet - why would it be impaired and what does Goodwill Impairment mean?
- Usually this happens when a company buys another one and the acquirer reassess what it really got out of the deal - customer relationships‚ brand name‚ and intellectual property - and finds that those “Assets” are worth significantly less than they originally thought.
- It often happens in acquisitions where the buyer “overpaid” for the seller and it can result in extremely negative Net Income on the I/S.
- It can also happen when a company discontinues part of its operations and must impair the associated Goodwill.
Walk me through how Depreciation going up by $10 would affect the statements.
- I/S: Operating Income and Pre-Tax Income would decline by $10 and‚ assuming a 40% tax rate‚ NI would go down by $6.
- SCF: The NI at the top goes down by $6‚ but the $10 Deprecation is a non-cash expense that gets added back‚ so overall CFO goes up by $4. There are no changes elsewhere‚ so the overall Net Change in Cash goes up by $4.
- B/S: PP&E goes down by $10 on the Assets side b/c of the Depreciation and Cash is up by $4 from the changes on the SCF. Overall‚ Assets is down by $6‚ Since NI fell by $6 as well‚ SE on the Liabilities & Equity side is down by $6 and both sides of the B/S balance.
- Intuition: We save on taxes with any non-cash charge‚ including Depreciation.
What happens when Accrued Expenses increases by $10
For this question‚ remember that Accrued Expenses are recognized on the I/S but haven’t been paid out in cash yet. So this could correspond to payment being set aside for an employee‚ but not actually the employee in cash yet.
• I/S: Operating Income and Pre-Tax Income fall by $10‚ and NI falls by $6 (assuming a 40% tax rate).
• SCF: NI is down by $6‚ and the increase in Accrued Expenses will increase Cash Flow by $10‚ so overall CFO is up by $4 and the Net Change in Cash at the bottom is up by $4.
• B/S: Cash is up by $4 as a result‚ so Assets is up by $4. On the Liabilities & Equity side‚ Accrued Expenses is a Liability‚ so Liabilities is up by $10 and SE (Retained Earnings) is down by $6 due to the NI decrease‚ so both sides balance.
• Intuition: We record an additional expense and save on taxes with it‚ but that expense hasn’t been paid in cash yet‚ so our cash balance is actually up.
What happens when Accrued Expenses decreases by $10 (i.e. it’s now paid out in the form of cash)? Do NOT take into account cumulative changes from previous increases in Accrued Expenses.
Assuming that you are not taking into account any previous increases (confirm this):
• I/S: There are no changes.
• SCF: The change in Accrued Expenses in the CFO section is negative $10 b/c you pay it out in cash‚ and so the cash at the bottom decreases by $10.
• B/S: Cash is down by $10 on the Assets side and Accrued Expenses is down by $10 on the other side‚ so it balances.
• Intuition: This is a simple cash payout of previously recorded expenses.
Accounts Receivable increases by $10. Walk me through the 3 statements.
If A/R increases by $10‚ it means that we’ve recorded revenue of $10 but haven’t received it in cash yet. For example‚ a customer has ordered a $10 product from us and we’ve delivered it‚ but we are still waiting on cash payment.
• I/S: Revenue is up by $10 and so is Pre-Tax Income‚ which means that Net Income is up by $6 assuming a 40% tax rate.
• SCF: NI is up by $6 but the A/R increase is a reduction in cash (since we don’t have the cash yet)‚ so we need to subtract $10‚ which results in cash at the bottom being down by $4.
• B/S: On the Assets side‚ Cash is down by $4 and A/R is up by $10‚ so the Assets side is up by $6. On the other side‚ SE is up by $6 b/c NI has increased by $6. Both sides balance.
• Intuition: When A/R increases‚ it means that we’ve paid taxes on additional revenue but haven’t received any of that revenue in cash yet‚ so our cash balance decreases by the additional amount in taxes we’ve paid.
