Accounting

Question 1

Figuring out changes on the statements for:

Changes to true cash item on I/S

Answer 1

e.g., revenue increases, COGS increase

> Pre-tax income changes
Net income changes
Cash changes
Retained earnings change (because NI changes)

Question 2

Figuring out changes on the statements for: Changes to non-cash or re-classified item on income statement

Answer 2

e.g., depreciation increases

> Pre-tax income changes
> Net income changes
> Cash changes
> Retained earnings change
> ** something else on balance sheet changes (e.g., PPE)

Question 3

What happens when A/R goes up?

e.g., +$10

Answer 3

Operational balance sheet item
> LOGICALLY what happens: Company records revenue that is not yet received in cash

> Revenue increases (+10), pre-tax income increases (+10), net income increases (+6 if assume tax rate = 40%)
Make adjustment on cash flow statement, so cash changes
Net income = +6
Less increase in A/R = -10 (we don’t have the cash yet)
Net change in cash = -4
Retained earnings increase (+6)
A/R increases (+10)
Cash changes (-4)

*When A/R increases, it means we have PAID TAXES on ADDITIONAL revenue, but have not yet received that revenue in cash yet, so our cash balance decreases by the additional amount of taxes paid

Question 4

What happens when A/R goes down?

Answer 4

Operational balance sheet item
> LOGICALLY what happens: Company receives cash for revenue already recognized

> NOTHING happens on I/S
Make adjustment on cash flow statement (+ cash)
Cash increases
A/R decreases

Question 5

What happens when prepaid expenses go up?

Answer 5

Operational balance sheet item
> LOGICALLY what happens: Company is prepaying for expense before incurring it

> NOTHING happens on I/S
Make adjustment on cash flow statement (- cash)
Cash decreases
Prepaid expense increases

Question 6

What happens when prepaid expenses go down?

e.g., -$10

Answer 6

Operational balance sheet item
> LOGICALLY what happens: Company is now incurring expenses already paid for

> Expenses increase (+10), pre-tax income decreases (-10), net income decreases (-6 if we assume tax rate = 40%)
> Make adjustment on cash flow statement (increase in cash from prepaid expense change)
Net income (-6)
Prepaid expenses (+10) 
Net change in cash (+4) 
> Cash changes (+4), prepaid expense decreases (-10), retained earnings decrease (-6)

Question 7

What happens when inventory increases?

Assume you pay for it with cash, +$10

Answer 7

Operational balance sheet item
> LOGICALLY what happens: Company is purchasing inventory but not yet sold

> No change to I/S
On cash flow statement, an increase in inventory is a reduction in cash (-10)
Cash decreases, inventory increases

Question 8

What happens when inventory decreases?

Answer 8

Operational balance sheet item
> LOGICALLY what happens: Company is selling the inventory and recognizing revenue and associated cost

> Revenue increases (ask to confirm this) 
> COGS increase
> Pre-tax income changes
> Net income changes
> Cash changes 
> Retained earnings change 
> Inventory decreases

Question 9

What happens when accrued expenses increase?

e.g., +$10

Answer 9

Operational balance sheet item
> LOGICALLY what happens: Company has accrued expenses that you have not yet paid; recognize expenses but no cash payment yet
> e.g., accrued wages

> Costs increase (+10)
> Pre-tax income decreases (-10)
> Net income decreases (-6, if tax rate = 40%)
> Make adjustment to cash flow statement
Net income = -6
Accrued expenses = +10
Net change in cash = +4
> Cash changes (+4)
> Retained earnings decrease (-6)
> Accrued expenses increase (+10)

Question 10

What happens when accrued expenses decrease?

e.g., -$10

Answer 10

Operational balance sheet item
> LOGICALLY what happens: Company is paying for expenses already incurred

> NOTHING happens on I/S
Cash flow statement = Accrued expenses decreases (-10)
Balance sheet: Cash decreases (-10), accrued expenses decrease (-10)

Question 11

What happens when accounts payable increases?

Answer 11

Operational balance sheet item
> Same as accrued expenses
> Company owes money to a supplier that it has not yet paid, but recognizes expense

> Costs increase
> Pre-tax income decreases 
> Net income decreases 
> Make adjustment to cash flow statement
> Cash changes
> Retained earnings decrease
> Accounts payable increases

Question 12

What happens when accounts payable decreases?

Answer 12

Operational balance sheet item
> Same as accrued expenses
> Company pays supplier what it owed

> NOTHING happens on I/S
Cash decreases, accounts payable decreases

Question 13

What happens when deferred revenue increases?

Answer 13

Operational balance sheet item
> LOGICALLY what happens: Company has COLLECTED cash from customer but it has NOT YET performed product delivery/service to recognize revenue

> NO change to I/S
Cash increases, deferred revenue increases

Question 14

What happens when deferred revenue decreases?

Answer 14

Operational balance sheet item
> LOGICALLY what happens: Company is now recognizing revenue for product delivery/service already received payment for

> Revenue increases
> Pre-tax income increases
> Net income increases
> Changes to statement of cash flows (+ net income, - deferred revenue account)
> Cash changes 
> Deferred revenue decreases
> Retained earnings increases

Question 15

Statement of cash flows - key sections

Answer 15

1) Cash flow from Operations
Net income
+ non-cash expenses (depreciation, amortization of intangibles, stock-based compensation, (gain)/loss on sale of PPE, asset write-downs, (liability) write downs)
- Increases in current assets
+ Decreases in current assets
+ Increases in current liabilities (incl: deferred revenue)
- Decreases in current liabilities (incl: deferred revenue)

2) Cash flow from Investing
\+ PPE Sale proceeds
- Capital expenditures
\+ Sell ST / LT investments
- Purchase ST / LT investments

3) Cash flow from Financing 
\+ Issue debt
- Repay debt
\+ Issue new shares
- Repurchase shares 
- Dividend issue

Question 16

What happens when non-operational balance sheet item or cash flow statement item changes?

Ex: 
Purchasing or selling securities 
Capex
Selling PPE
Raising debt
Issuing stock
Repurchasing stock
Issuing dividend

Answer 16

NO change to I/S

> Cash changes
Corresponding Balance Sheet item also changes

CF statement > Balance sheet item link:

1) Purchasing or selling securities —> ST or LT investments, CFI
2) Capex –> PPE, CFI
3) Selling PPE –> PPE, CFI
4) Raising debt –> Debt, CFF
5) Issuing stock –> Shareholder’s equity, CFF
6) Repurchasing stock –> Shareholder’s equity, CFF
7) Issuing dividend –> Shareholder’s equity, CFF

Question 17

Where do other gains and losses show up on I/S? Are these non cash items?

Answer 17

Right after interest expense

Other gains and losses include things that are not part of the company’s core business operations, such as:
> Gains and losses on sale of PPE (non-cash, e.g., sell PP&E more than book value)
> Impairment charges (Non-cash)
> Write-downs (Non-cash)

Non cash because they correspond to long term assets purchased in PRIOR periods

Question 18

Walk me through the 3 financial statements

Answer 18

There are 3 key financial statements: Income Statement, Cash Flow Statement, and Balance Sheet

The income statement shows the company’s REVENUES, EXPENSES and NET INCOME over a specific period of time

The cash flow statement shows the company’s NET CHANGE in cash. It starts with Net Income from the I/S, adds back non-cash expenses and adjusts for changes in OPERATING ASSETS and LIABILITIES (working capital accounts). It also shows how the company has SPENT cash or RECEIVED cash from investing or financing activities

The balance sheet is a SNAPSHOT of the company’s financial health. It shows ASSETS, LIABILITIES and SHAREHOLDERS’ Equity at a specific point in time. Assets must equal Liabilities plus Shareholders’ Equity

Question 19

Let’s say I could only look at 2 statements to assess a company’s prospects – which 2 would I use and why

Answer 19

Income statement and balance sheet (assuming you have beginning and ending balances) –> you can CREATE cash flow statement from both

Question 20

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?

Answer 20

Ask yourself WHICH DIRECTION cash will move in the future

If the new item will INCREASE cash in the future (e.g., sale of inventory), then it is an asset

If the new item will DECREASE cash in the future (e.g., deferred revenue leads to higher taxes in the future), then it is a liability

Question 21

How can you tell whether or not an expense should appear on the Income Statement?

Answer 21

Two conditions must be met:

1) It is tax-deductible (in order to get to net income)
2) It is incurred in the current period

e.g., repaying debt is NOT an expense because it is NOT tax deductible

Question 22

Income statement - key sections

Answer 22

Revenue
Less: COGS
Gross profit
Less: S&GA
Less: D&A
EBITDA
Less: D&A
EBIT (Operating Income)
Less: Interest 
EBT (Pre-tax income)
Less: Cash taxes
Net income

Question 23

Wait, so what’s the difference between Accounts Receivable and Deferred Revenue? They sound similar.

Answer 23

1) A/R represents cash that our customers have NOT yet given to us, whereas Deferred Revenue cash has already been collected
2) A/R is for a product/service that HAS ALREADY BEEN DELIVERED, whereas Deferred Revenue is for product/service that HAS NOT yet been delivered
3) A/R is an asset, while Deferred Revenue is a liability

Both accounts relate to CUSTOMERS

Question 24

You see an “Investments in Equity Interests” (AKA Associate Companies) line item on the Assets side of a firm’s Balance Sheet. What does this mean?

Answer 24

When a company owns more than 20% but less than 50% of ANOTHER COMPANY, Investments in Equity Interests represents this portion that the company DOES OWN

(vs. Minority interests, for companies that own over 50%, minority interests represents the remaining portion they DO NOT own)

Question 25

Could you ever have negative Shareholders’ Equity? What does it mean?

Answer 25

Yes, it is common in 2 scenarios: 1) LBO with dividend recaps > owner has taken out a LARGE PORTION OF EQUITY 2) If the company is losing money consistently, so retained earnings balance is declining > Shows that the company is struggling But Shareholders' Equity is DIFFERENT from Equity Value (market cap) which can never be negative

Question 26

Working capital vs operating working capital?

Answer 26

Working capital is defined as Current Assets - Current Liabilities Operating Working Capital is more commonly used in finance, and defined as (Current Assets - Cash and investments) - (Current Liabilities - Debt) > excludes items related to investment and financing activities > we care about operationally-related balance sheet items

Question 27

What does negative operating working capital mean? Is it a bad sign?

Answer 27

Negative operating working capital means current liabilities exceed current assets > e.g., large amount of cash outlay, or large amount of credit extended > NOT the same as negative CHANGE in NWC Not necessarily a bad sign. Common in certain industries: > Retail and restaurant: take a long time to pay suppliers (so high A/P) > Companies with subscriptions or longer term contracts have high deferred revenue balances that result in negative working capital

Question 28

When would goodwill be impaired? What does that mean?

Answer 28

Goodwill might become impaired if an acquirer later finds out that they OVERPAID for a company and the assets they received are worth significantly less than what they originally thought Or happens when a company DISCONTINUES a part of the operations and must impair the associated goodwill

Question 29

Walk me through how Depreciation going up by $10 would affect the statements?

Answer 29

Starting with I/S: > D&A expense increases by $10 > Pre-tax income decreases by $10 > Net income decreases by 10*(1-40% tax) = $6 Net income becomes the first line of the Cash Flow Statement > Add back non-cash expense of $10 > No other changes > Overall change in cash is +$4 ``` On balance sheet: > Cash increases by $4 > PPE decreases by $10 > Net change in assets: -$6 > Retained earnings (Shareholders' equity) decreases by $6 > Net change in L+E = -$6 ``` Balance sheet balances

Question 30

Working capital items --> what increases CF? What decreases CF?

Answer 30

Increases CF: > Decreases in current assets > Increases in current liabilities Decreases CF: > Increases current assets (e.g., purchase inventory, extend credit to customers and pay additional taxes) > Decreases current liabilities

Question 31

***A company sells some of its PP&E for $120. On the Balance Sheet, the PP&E is worth $100. Walk me through how the 3 statements change.

Answer 31

LOGICALLY what happens: You are selling PP&E for MORE than what its book value is > We have a NON CASH gain (need to adjust CFO) IS: > Record GAIN (+$20) > Pre-tax net income increases by 20 > Net income increases by 12 (assumes 40% tax rate) ``` Cash flow statement: > Net income +12 > ***********Subtract non-cash gain (-20) > CFO -8 > CFI: Proceeds from sale +120 (no need to get rid of book value here) > Change in cash: +112 ``` Balance sheet: > Cash increases 112 > PPE decreases 100 (book value) > Retained earnings increase by 12

Question 32

***Walk me through what happens on the 3 statements when there’s an Asset Write-Down of $100.

Answer 32

LOGICALLY what happens: Write down of asset is NON-CASH CHARGE (expense) > reduction in book value of an asset (when FMV has fallen below the carrying book value) > shows up after interest expense on IS > in the below example, non-cash asset write-down is assumed to be tax deductible IS: Asset write down reduces pre-tax income by 100 and net income by 60 (assumes 40% tax rate) ``` Cash flow statement: > Net income -60 > Asset write-down +100 > CFO +40 > Change in cash +40 ``` Balance sheet: > Cash +40 > Asset affected -100 > Retained earnings -60

Question 33

Explain what happens on the 3 statements when a company issues $100 worth of shares to investors.

Answer 33

LOGICALLY what happens: Company receives $100 from issuance of equity > financing No change to I/S (nothing tax deductible here) Cash flow statement: > CFF: +100 from issuance of equity Balance sheet: > Cash increases $100 > Common stock increases $100

Question 34

Let’s say we have the same scenario, but now instead of issuing $100 worth of stock to investors, the company issues $100 worth of stock to employees in the form of Stock-Based Compensation. What happens?

Answer 34

LOGICALLY what happens: NON-CASH, it is treated as an ADDITIONAL EXPENSE because it is now TAXABLE and a CURRENT expense > Treated similarly to operating expense like WAGES (to EMPLOYEES) > Shows up after interest expense IS: > Pre-tax income falls by $100 > NI decreases by $60 (assumes 40% tax rate) ``` Cash flow statement: > NI -60 > Stock-based compensation +100 > CFO +40 (Nothing changes in CFF) ``` Balance sheet: > Cash + 40 > Common Stock and APIC +100 > Retained earnings -60

Question 35

A company decides to issue $100 in Dividends – how do the 3 statements change?

Answer 35

LOGICALLY what happens: Issuing CASH dividend to shareholders (outflow) > non-operational CFS / BS item that just changes cash and RE, nothing else IS: No changes (not tax deductible) Cash flow statement: > CFF -100 Balance sheet: > Cash -100 > Retained earnings -100

Question 36

**A company has recorded $100 in income tax expense on its Income Statement. All $100 of it is paid, in cash, in the current period. Now we change it and only $90 of it is paid in cash, with $10 being deferred to future periods. How do the statements change?

Answer 36

LOGICALLY what happens: We are DEFERRING some taxes, which saves us on cash in the current period, at the expense of additional cash taxes in the future > creating Deferred Tax Liability account IS: > Nothing changes: Both current and deferred taxes are recorded as "Taxes" > NI only changes if TOTAL AMOUNT of taxes changes Cash flow statement: > CFO: DTL +10 Balance sheet: > Cash +10 > DTL + 10

Question 37

Walk me through a $100 “bailout” of a company and how it affects the 3 statements

Answer 37

LOGICALLY what happens: Bailout refers to when some entity provides monetary support to a company facing potential bankruptcy > Treat as a normal STOCK ISSUANCE **Start off by confirming the type of bailout: Debt, equity, combination > most common scenario is Equity or Preferred Stock investment from the GOVERNMENT IS: No changes Cash flow statement: > CFF: +100 to reflect new investment Balance sheet: > Cash +100 > *Shareholders' Equity +100 (either Common stock or Preferred Stock)

Question 38

**Walk me through a $100 Write-Down of Debt – as in OWED Debt, a Liability – on a company’s Balance Sheet and how it affects the 3 statements

Answer 38

LOGICALLY what happens: Company no longer has to pay $100 in owed debt > LIABILITY is written down, recorded as ADDITION on I/S (non cash) I/S: **> Pre-tax income GOES UP by $100 > NI +60 (assumes 40% tax rate) ``` Cash flow statement: > NI +60 > Debt write-down -100 (non-cash) > CFO -40 *no change to CFF because no debt is being paid down, just a write-down ``` Balance sheet: > Cash -40 > Debt -100 > NI +60 Follow up Questions: A) If writing down liabilities boosts NI, why don't companies do it all the time? > may help in the ST > but LT it hurts the company's credibility and ability to borrow in the future > inability to borrow again will hurt far more than a reduced net income would

Question 39

Asset vs liability write downs

Answer 39

Asset write down = record as an EXPENSE on I/S > add back in Cash flow statement Liability write down = record as an ADDITION on I/S > subtract in Cash flow statement

Question 40

Multi-step scenario: 1) Let’s say Apple is buying $100 worth of new iPad factories with debt. How are all 3 statements affected at the start of “Year 1,” before anything else happens? 2) Now let’s go out one year, to the start of Year 2. Assume the Debt is highyield, so no principal is paid off, and assume an interest rate of 10%. Also assume the factories Depreciate at a rate of 10% per year. What happens now? Assume that we have already factored in the changes from Part 1 and are only tracking what happens AFTER those have taken place. **3) At the end of Year 2, the factories all break down and their value is written down to $0. The loan must also be paid back now. Walk me through how the 3 statements ONLY from the start of Year 2 to the end of Year 2.

Answer 40

1) LOGICALLY what happens: buying PPE at the start of Year 1 WITH DEBT (NOT cash) > I/S: no change (no period yet) > Cash flow statement: CFF: +100 (debt), CFI: -100 (Capex) > Balance sheet: Cash 0, PPE +100, Debt +100 2) LOGICALLY what happens: 1 year has passed; Pay interest (10% of debt balance), record factory depreciation > Annual depreciation expense 10%*100 = 10 > Annual interest expense 10%*100 = 10 > NO change to debt balance ``` I/S: > D&A expense (non-cash) +10 > Interest expense +10 > Pre-tax income -20 > NI -12 (assumes 40% tax rate) ``` Cash flow statement: > NI -12 > D&A (non-cash) +10 > CFO -2 ``` Balance sheet: > Cash -2 > PPE -10 > Retained earnings -12 > no change to debt account (because no principal is paid off, no additional liability is created) ``` 3) LOGICALLY what happens: 2 years in TOTAL have passed; write down value of PPE, repay principal debt > 1 year activity: record 1 year of depreciation, pay another year of interest *** > End of year activity: repay debt, write down PPE > end of 2 years value of PPE = 100 - 2 years of depreciation = 80 ``` I/S: > Depreciation (non-cash) -10 ** > Asset write down (non-cash) -80 ** > Interest expense -10 > Pre-tax income -100 > NI -60 ``` ``` Cash flow statement: > NI -60 > Depreciation +10 > Asset write down +80 > CFO +30 > CFF repay debt -100 > Cash -70 ``` ``` Balance sheet: > Cash -70 > PPE -90 (10 depreciation, 80 write-down)** > Retained earnings -60 > Debt -100 ```

Question 41

Multi-step scenario: 1) Assume Apple is ordering $10 of additional iPad Inventory, using cash on hand. They order the Inventory, but they have not manufactured or sold anything yet – what happens to the 3 statements? 2) Now let’s say they sell the iPads for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario.

Answer 41

1) LOGICALLY what happens: Company buys inventory using cash I/S: No change (no sale yet) Cash flow statement: Inventory purchase -10 (cash) Balance sheet: Cash -10, inventory +10 2) LOGICALLY what happens: iPad sale now (recognize revenue and COGS) > assume cash sale ``` I/S: > Revenue +20 > COGS +10 > Gross profit, Operating income and Pre-tax income +10 > NI +6 (assumes 40% tax rate) ``` Cash flow statement: > NI +6 > Inventory decrease +10 > CFO +16 Balance sheet: > Cash +16 > Inventory -10 > Retained earnings +6

Question 42

Multi-step scenario: 1) A company raises $100 worth of Debt, at 5% interest and 10% yearly principal repayment, to purchase $100 worth of Short-Term Securities with 10% interest attached. Walk me through how the 3 statements change IMMEDIATELY AFTER this initial purchase **2) Now walk me through what happens at the end of Year 1, after the company has earned interest, paid interest, and paid back some of the debt principal. 3) Now let’s say that at the end of year 1, the company sells the $100 of Short Term Securities but gets a price of $110 for them instead. It also uses the proceeds to repay the $90 worth of remaining Debt. Walk me through the statements after ONLY these changes.

Answer 42

1) LOGICALLY what happens: Debt raise with yearly principal repayment, purchase of ST securities that generate additional income > immediately after initial purchase ``` I/S: No change yet (no time has passed) Cash flow statement: > CFI: ST securities investment -100 > CFF: Debt issuance +100 > Cash flow 0 ``` Balance sheet: > Cash 0 > ST securities +100 > Debt +100 2) LOGICALLY what happens: 1 year has passed, recognize interest income, pay interest on debt, and pay some principal > 1 year Interest income 10%*100 = 10 ---> CASH > Year 1 interest on debt 5%*100 = 5 (assume on beginning balance) > Yearly debt repayment 10%*100 = 10 ``` I/S: > Interest expense +5 > Interest income +10 (CASH)** > Pre-tax income +5 > NI +3 ``` Cash flow statement: > NI +3 > CFF partial debt repayment -10 > Cash -7 Balance sheet: > Cash -7 > Retained earnings +3 > Debt -10 3) LOGICALLY what happens: Gain on sale of ST securities, repay $90 worth of remaining debt using proceeds > Gain on sale of securities is non-cash > assume we already walked through other changes in Q2 I/S: > Gain on sale of securities +10 > Pre-tax income +10 > NI +6 (assumes 40% tax rate) ``` Cash flow statement: > NI +6 > Gain on sale of securities -10 (non cash) > CFO -4 > CFI sale of securities +110 > CFF debt repayment -90 > Cash +16 ``` ``` Balance sheet: > Cash +16 > ST securities -100 (book value wiped out) > Debt -90 > Retained earnings +6 ```

Question 43

What is the difference between income tax payable and deferred tax liability?

Answer 43

Income Tax Payable - taxes that a company has INCURRED and has not yet paid during that period, BUT has recognized as an expense on I/S > Dr: Income tax expense > Cr: Income tax liability Deferred tax liability - unpaid tax liability upon which payment is deferred until a FUTURE tax year, due to DIFFERENCES between tax accounting and standard accounting principles