Accounting

Question 1

Walk me through the 3 financial statements.

Answer 1

• 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.

Question 2

Can you give me examples of major line items on each of the financial statements?

Answer 2

• 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

Question 3

How do the 3 statements link together?

Answer 3

• 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.

Question 4

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?

Answer 4

• 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.

Question 5

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

Answer 5

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.

Question 6

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 6

• 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.

Question 7

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

Answer 7

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).

Question 8

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?

Answer 8

• 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.”

Question 9

How do you decide when to capitalize rather than expense a purchase?

Answer 9

• 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.

Question 10

If Depreciation is a non-cash expense‚ why does it affect the cash balance?

Answer 10

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.

Question 11

Where does Depreciation usually appear on the Income Statement?

Answer 11

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.

Question 12

Why is the Income Statement not affected by Inventory purchases?

Answer 12

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.

Question 13

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!

Answer 13

• 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.

Question 14

What’s the difference between Accounts Payable and Accrued Expenses?

Answer 14

• 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.

Question 15

When would a company collect cash from a customer and NOT record it as revenue?

Answer 15

• 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.

Question 16

If cash collected is not recorded as revenue‚ what happens to it?

Answer 16

• 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.

Question 17

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!

Answer 17

• 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.

Question 18

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

Answer 18

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.

Question 19

How long does it usually take for a company to collect its Accounts Receivable balance?

Answer 19

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.

Question 20

How are Prepaid Expenses and Accounts Payable different?

Answer 20

It’s similar to the difference between A/R and Deferred Revenue:

1. 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.
2. 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.

Question 21

You’re reviewing a company’s Balance Sheet and you see an “Income Taxes Payable” line item on the Liabilities side. What is this?

Answer 21

• 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.

Question 22

You see a “Noncontrolling Interest” (AKA Minority Interest) line item on the Liabilities side of a company’s Balance Sheet. What does this mean?

Answer 22

• 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.

Question 23

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?

Answer 23

• 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.

Question 24

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

Answer 24

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.

Question 25

What is Working Capital? How is it used?

Answer 25

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.

Question 26

“Short-Term Investments” is a Current Asset - should you count it in Working Capital?

Answer 26

• 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).

Question 27

What does negative (Operating) Working Capital mean? Is that a bad sign?

Answer 27

Not necessarily. It depends on the type of company and the specific situation - here are a few different things it could mean:

1. Some companies with subscriptions or longer-term contracts often have negative Working Capital b/c of high Deferred Revenue balances.
2. 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.
3. 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).

Question 28

What’s the difference between cash-based and accrual accounting?

Answer 28

• 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).

Question 29

Let’s say a customer pays for a TV with a credit card. What would this look like under cash-based vs. accrual accounting?

Answer 29

• 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.

Question 30

Why do companies report GAAP or IFRS earnings‚ AND non-GAAP/ non-IFRS (or “Pro-Forma”) earnings?

Answer 30

• 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.”

Question 31

A company has had positive EBITDA for the past 10 years‚ but it recently went bankrupt. How could this happen?

Answer 31

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.

Question 32

Normally Goodwill remains constant on the Balance Sheet - why would it be impaired and what does Goodwill Impairment mean?

Answer 32

• 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.

Question 33

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

Answer 33

• 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.

Question 34

What happens when Accrued Expenses increases by $10

Answer 34

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.

Question 35

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.

Answer 35

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.

Question 36

Accounts Receivable increases by $10. Walk me through the 3 statements.

Answer 36

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.

Question 37

Prepaid Expenses decreases by $10. Walk me through the statements. Do NOT take into account cumulative changes from previous increases in Prepaid Expenses.

Answer 37

When Prepaid Expenses “decrease‚” it means that expenses are now recognized on the I/S. For example‚ we’ve previously paid for an insurance policy in cash and have now recognized that same expense on the I/S.
• I/S: Pre-Tax Income is down by $10 and NI is down by $6.
• SCF: NI is down by $6 but since Prepaid Expense is an Asset‚ a decrease of $10 results in an increase of $10 in cash. At the bottom of the SCF‚ cash is up by $4 as a result.
• B/S: On the Assets side‚ Cash is up by $4 and Prepaid Expense is down by $10‚ so the Assets side is down by $6 overall. On the other side‚ SE is down by $6 b/c of the reduced NI‚ so both sides balance.
• Intuition: Here‚ we’re losing NI and paying additional taxes‚ but we’ve already paid out these expenses in cash previously. So our Cash balance goes up rather than down‚ despite the additional I/S expenses.

Question 38

What happens when Inventory goes up by $10‚ assuming you pay for it with cash?

Answer 38

• I/S: No changes.
• SCF: Inventory is an Asset so that reduces CFO - it goes down by $10‚ as does the Net Change in Cash at the bottom.
• B/S: On the Assets side‚ Inventory is up by $10 but Cash is down by $10‚ so the changes cancel out and Assets still equals Liabilities & Equity.
• Intuition: We’ve spent cash to buy Inventory‚ but haven’t manufactured or sold anything yet.

Question 39

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 39

• I/S: You record a Gain of $20 ($120 - $100)‚ which boosts Pre-Tax Income by $20. At a 40% tax rate‚ Net Income is up by $12.
• SCF: Net Income is up by $12‚ but you need to subtract out that Gain of $20‚ so CFO is down by $8. Then‚ in CFI‚ you record the entire amount of proceeds from the sale‚ $120‚ so that section is up by $120. At the bottom of the SCF‚ cash is therefore up by $112.
• B/S: Cash is up by $112‚ but PP&E is down by $100 since we’ve sold it‚ so the Assets side is up by $12. The other side is up by $12 as well‚ since SE is up by $12 due to the NI increase.
• Intuition: Gains and Losses are not non-cash‚ but they are re-classified on the SCF. The cash increase here simply reflects the after-tax profit from the Gain - if we had sold the PP&E at its Balance Sheet value‚ there would be no change on the I/S.

Question 40

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

Answer 40

• I/S: The $100 Write-Down reduces Pre-Tax Income by $100. With a 40% tax rate‚ NI declines by $60.
• SCF: NI is down by $60‚ but the Write-Down is a non-cash expense‚ so we add it back - and therefore CFO increases by $40. Cash at the bottom is up by $40.
• B/S: Cash is now up by $40 and an Asset is down by $100 (it’s not clear which Asset since the question never stated it). Overall‚ the Assets side is down by $60. On the other side‚ since NI was down by $60‚ SE is also down by $60 - and both sides balance.
• Intuition: The same as any other non-cash charge: we save on taxes‚ so our Cash goes up‚ and something on the B/S changes in response.

Question 41

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

Answer 41

• I/S: No changes (since this doesn’t affect taxes and since the shares will be around for years to come).
• SCF: CFF is up by $100 due to this share issuance‚ so cash at the bottom is up by $100.
• B/S: Cash is up by $100 on the Asset’s side and SE (Common Stock & APIC) is up by $100 on the other side to balance it.
• Intuition: This one does not affect taxes and does not correspond to the current period‚ so it doesn’t show up on the I/S - just like similar items‚ all that changes is Cash and then something else on the B/S.

Question 42

Let’s say 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 42

• I/S: You need to record this as an additional expense b/c it’s now a tax-deductible and a current expense‚ Pre-Tax Income falls by $100 and NI falls by $60 (assuming a 40% tax rate).
• SCF: NI is down by $60 but you add back the SBC of $100 since it’s a non-cash charge‚ so cash at the bottom is up by $40.
• B/S: Cash is up by $40 on the Assets side. On the other side‚ Common Stock & APIC is up by $100 due to the SBC‚ but RE is down by $60 due to the reduced NI‚ so SE is up by $40 and both sides balance.
• Intuition: This is a non-cash charge‚ so like all non-cash charges it impacts the I/S and affects one B/S item in addition to Cash and RE - in this case‚ it flows into Common Stock & APIC b/c that one reflects the market value of stock at the time the stock was issued. The cash increase here simply reflects the tax savings.

Question 43

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

Answer 43

• I/S: No changes. Dividends count as a financing activity and are not tax-deductible‚ so they never appear on the I/S.
• SCF: CFF is down by $100 due to the Dividends‚ so cash at the bottom is down by $100.
• B/S: Cash is down by $100 on the Assets side‚ and SE (RE) is down by $100 on the other side‚ so both sides balance.
• Intuition: This is another non-operational CFS/BS item‚ so it is a simple use of cash and nothing else changes.

Question 44

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 44

• I/S: Nothing changes. Both Current and Deferred Taxes are recorded simply as “Taxes” and NI remains the same. NI changes only if the total amount of taxes changes.
• SCF: NI remains the same but we add back the $10 worth of Deferred Taxes in CFO - no other changes‚ so cash at the bottom is up by $10.
• B/S: Cash is up by $10 and so the entire Assets side is up by $10. On the other side‚ the DTL is up by $10 and so both sides balance.
• Intuition: Deferred Taxes saves us cash in the current period‚ at the expense of additional cash taxes in the future.

Question 45

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

Answer 45

First‚ confirm what type of “bailout” this is - Debt? Equity? A combination? The most common scenario here is an Equity (Preferred Stock) investment from the government‚ so here’s what happens:
• I/S: No changes.
• SCF: CFF goes up by $100 to reflect this new investment‚ so the Net Change in Cash is up by $100.
• B/S: Cash is up by $100 so the Assets side is up by $100; on the other side‚ SE goes up by $100 to make it balance (Common Stock & APIC for a normal equity investment or Preferred Stock for preferred).
• Intuition: It’s the same as a normal stock issuance: no I/S changes b/c nothing affects the company’s taxes.

Question 46

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 46

This one is counter-intuitive. When a Liability is written down‚ you record it as an addition on the I/S (with an asset write-down‚ it’s a subtraction).
• I/S: Pre-Tax Income goes up by $100‚ and assuming a 40% tax rate‚ NI is up by $60.
• SCF: NI is up by $60‚ but we need to subtract that Debt Write-Down b/c it was non-cash - CFO is down by $40‚ and Cash is down by $40 at the bottom.
• B/S: Cash is down by $40 so the Assets side is down by $40. On the other side‚ Debt is down by $100 but SE is up by $60 b/c the NI was up by $60 - so Liabilities & SE is down by $40 and both sides balance.
• Intuition: One way to think about this is that writing down Assets is “bad” for us b/c it reduces our ability to generate future cash flow‚ but writing down Liabilities is “good” b/c it reduces our future expenses (sort of). I don’t recommend presenting it like that in an interview.

Question 47

If writing down Liabilities boosts Net Income‚ why don’t companies just do it all the time? It helps them out!

Answer 47

• This is like asking‚ “If declaring bankruptcy helps you relieve your obligations‚ why not do it whenever you rack up debt?”
• And the answer is similar: b/c it may help in the short-term‚ but in the long-term it hurts the company’s credibility and ability to borrow in the future. If a company continually writes down its Liabilities‚ investors will stop trusting it - and the inability to borrow again will hurt it far more than a reduced NI would.

Question 48

What’s the difference between LIFO and FIFO? Can you walk me through an example of how they differ?

Answer 48

• First‚ note that this question does not apply to you if you’re outside the US b/c IFRS does not permit the use of LIFO.
• LIFO stands for “Last-In‚ First-Out” and FIFO stands for “First-In‚ First-Out” - they are 2 different ways of recording the value of Inventory and the Cost of Goods Sold (COGS).
• With LIFO‚ you use the value of the most recent Inventory additions for COGS‚ but w/ FIFO‚ you use the value of the oldest Inventory additions for COGS.
• Here’s an example: let’s say your starting Inventory balance is $100 (10 units valued at $10 each). You add 10 units each quarter for $12 each in Q1 ($120 total)‚ $15 each in Q2 ($150 total)‚ $17 each in Q3 ($170 total)‚ and $20 each in Q4 ($200 total).
• You sell 40 of these units throughout the year for $30 each. In both LIFO and FIFO‚ you record 40 * $30 = $1200 for the annual revenue.
• The difference is that in LIFO‚ you would use the 40 most recent Inventory purchase values ($120 + $150 + $170 + $200) for the COGS‚ whereas in FIFO you would use the 40 oldest Inventory values ($100 + $120 + $150 + $170) for COGS.
• As a result‚ the LIFO COGS would be $640 and FIFO COGS would be $540‚ so LIFO would also have a lower Pre-Tax Income and NI. The ending Inventory value would be $100 higher under FIFO and $100 lower under LIFO.
• If Inventory is getting more expensive to purchase‚ LIFO will produce higher value for COGS and lower ending Inventory values and vice versa if Inventory is getting cheaper to purchase.

Question 49

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?

Answer 49

• I/S: At the start of “Year 1‚” there are no changes yet.
• SCF: The $100 worth of CapEx would show up under CFI as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of Debt raised would up as an addition to CFF‚ canceling out the investment activity. So the cash number stays the same‚ for now.
• B/S: There is now an additional $100 worth of factories‚ so PP&E is up by $100 and Assets is therefore up by $100. On the other side‚ Debt is up by $100‚ so the entire other side is up by $100 and both sides balance.

Question 50

• Let’s say Apple is buying $100 worth of new iPad factories with debt. Now let’s go out one year‚ to the start of Year 2. Assume the Debt is high-yield‚ 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.

Answer 50

• I/S: Operating Income decreases by $10 due to the 10% Depreciation charge each year‚ and the $10 in additional Interest Expense decreases the Pre-Tax Income by $20 altogether ($10 from the Depreciation and $10 from Interest Expense). Assuming a tax rate of 40%‚ NI falls by $12.
• SCF: NI at the top is down by $12. Depreciation is a non-cash expense‚ so you add it back and the end result is that CFO is down by $2. That’s the only change on the SCF‚ so overall cash is down by $2.
• B/S: On the Assets side‚ Cash is down by $2 and PP&E is down by $10 due to the Depreciation‚ so overall the Assets side is down by $12. On the other side‚ NI was down by $12‚ SE is also down by $12 and both sides balance.
• Remember that the Debt number itself does not change since we’ve assumed that nothing is paid back.

Question 51

Let’s say Apple is buying $100 worth of new iPad factories with debt. 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 change ONLY from the start of Year 2 to the end of Year 2.

Answer 51

After 2 years‚ the value of the factories is now $80 if we go with the 10% Depreciation per year assumption. It is this $80 that we will write down on the 3 statements. Also‚ don’t forget about the Interest Expense - it still needs to be paid in Year 2.
• I/S: We have $10 worth of Depreciation and then the $80 Write-Down. We also have $10 of additional Interest Expense‚ so Pre-Tax Income is down by $100. NI is down by $60 at a 40% tax rate.
• SCF: NI is down by $60 but the Write-Down and Depreciation are both non-cash expenses‚ so we add them back and cash flow is up by $30 so far. There are no changes under CFI‚ but under CFF there is a $100 charge for the loan payback - so CFF falls by $100. Overall cash at the bottom decreases by $70.
• B/S: Cash is now down by $70‚ and PP&E has decreased by $90‚ so the Assets side is down by $160. On the other side‚ Debt is down by $100 since it was paid off‚ and since NI was down by $60‚ SE is down by $60. Both sides are down by $160 and balance.

Question 52

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?

Answer 52

• I/S: No changes.
• SCF: Inventory is up by $10‚ so CFO decreases by $10. There are no further changes‚ so overall Cash is down by $10.
• B/S: Inventory is up by $10 and Cash is down by $10 so the Assets number stays the same and the B/S remains in balance.

Question 53

Let’s say Apple sells iPads for revenue of $20‚ at a cost of $10. Walk me through the 3 statements under this scenario.

Answer 53

• I/S: Revenue is up by $20 and COGS is up by $10‚ so Gross Profit‚ Operating Income‚ and Pre-Tax Income are all up by $10. Assuming a 40% tax rate‚ NI is up by $6.
• SCF: NI at the top is up by $6 and Inventory has decreased by $10 (since we just manufactured the Inventory into real iPads)‚ which is a net addition to cash flow - so CFO is up by $16 overall. These are the only changes on the CFS‚ so cash at the bottom is up by $16.
• B/S: Cash is up by $16 and Inventory is down by $10‚ so the Assets side is up by $6 overall. On the other side‚ NI was up by $6‚ so SE is up by $6 and both sides balance.
• Intuition: This simply reflects the sale of products at a certain cost‚ and the after-tax profit from that. The only tricky part is how Cash increases by $16‚ not $6 - that just reflects the “release” in net working capital you get from selling off the Inventory.

Question 54

• 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.

Answer 54

• I/S: No changes yet.
• SCF: The $100 Purchase of Short-Term Securities shows up as a reduction of cash flow under CFI‚ and the $100 Debt raised shows up as a $100 increase under CFF. Cash at the bottom is unchanged.
• B/S: Short-Term Securities on the Assets side is up by $100‚ and Debt on the Liabilities side is up by $100 so both sides balance.

Question 55

• 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 what happens at the end of Year 1‚ after the company has earned interest‚ paid interest‚ and paid back some of the debt principal.

Answer 55

• I/S: Interest Income is $10 ($100 * 10%) and Interest Expense is $5 ($100 * 5%)‚ so Pre-Tax Income increases by $5‚ and NI increases by $3 assuming a 40% tax rate.
• SCF: NI is up by $3. In CFF‚ we repay $10 worth of debt ($100 * 10%)‚ so cash at the bottom is down by $7.
• B/S: Cash on the Assets side is down by $7‚ so the Assets side is down by $7. On the other side‚ Debt is down by $10 due to the repayment and SE (RE) is up by $3 due to the NI‚ so this side is also down by $7 and the B/S balances.

Question 56

• 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. 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 56

• I/S: You record a Gain of $10 ($110 - $100)‚ so Pre-Tax Income is up by $10 and NI is up by $6 with a 40% tax rate.
• SCF: NI is up by $6 but you subtract the Gain of $10‚ so CFO is down by $4. Under CFI‚ you record the $110 as an addition to cash flow‚ so cash is up by $106 so far. Then under‚ CFF‚ you pay off $90 worth of Debt‚ which reduces cash by $90. Overall‚ Cash at the bottom is up by $16.
• B/S: Cash on the Assets side is up by $16 but Short-Term Securities is down by $100‚ so the Assets side is down by $84. On the other side‚ Debt is down by $90 but SE (RE) is up by $6 due to the NI increase‚ so that side is also down by $84 and both sides balance.

Question 57

Explain what a Deferred Tax Asset or Deferred Tax Liability is. How do they usually get created?

Answer 57

• A Deferred Tax Liability (DTL) means that you need to pay additional cash taxes in the future - in other words‚ you’ve underpaid on taxes and need to make up for it in the future.
• A Deferred Tax Asset (DTA) means that you can pay less in cash taxes in the future - you’ve paid too much before‚ and now you get to save on taxes in the future.
• Both DTLs and DTAs arise b/c of temporary differences between what a company can deduct for cash tax purposes and what they can deduct for book tax purposes. You see them most often in 3 scenarios:
1. When companies record Depreciation differently for book and tax purposes (i.e. more quickly for tax purposes to save on taxes)
2. When Assets get written up for book‚ but not tax purposes‚ in M&A deals.
3. When pension contributions get recognized differently for book vs. tax purposes.

Question 58

How can both DTAs and DTLs exist at the same time on a company’s Balance Sheet? How can they both owe and save on taxes in the future?

Answer 58

• This one’s subtle‚ but you frequently see both of these items on the statements b/c a company can owe AND save on future taxes - for different reasons.
• For example‚ they might have Net Operating Losses (NOLs) b/c they were unprofitable in early years‚ and those NOLs could be counted as DTAs.
• But they might also record accelerated Depreciation for tax purposes‚ but straight-line it for book purposes‚ which would result in a DTL in early years.

Question 59

How do Income Taxes Payable and Income Taxes Receivable differ from DTLs and DTAs? Aren’t they the same concept?

Answer 59

• They are similar but not the exact same idea. Income Taxes Payable and Receivable are accrual accounts for taxes that are owed for the CURRENT YEAR.
• For example‚ if a company owes $300 in taxes at the end of each quarter during the year‚ on its monthly financial statements it would increment Income Taxes Payable by $100 each month until it pays out everything in the cash at the end of 3 months‚ at which point Income Taxes Payable would decrease once again.
• By contrast‚ DTAs and DTLs tend to be longer-term and arise b/c of events that do NOT occur in the normal course of business.

Question 60

Walk me through how you project revenue for a company.

Answer 60

• The simplest way to do it is to assume a percentage growth rate - for example‚ 15% in Year 1‚ 12% in Year 2‚ 10% in Year 3‚ and so on‚ usually decreasing significantly over time. To be more precise‚ you could create a “bottoms-up build” or a “tops-down build:”
• BOTTOMS-UP: Start w/ individual products/customers‚ estimate the average sale value or customer value‚ and then the growth rate in customers/transactions and customer transaction values to tie everything together.
• TOPS-DOWN: Start w/ “big-picture” metrics like overall market size‚ and then estimate the company’s market share and how that will change in coming years and multiply to get their revenue.
• Of these two methods‚ bottoms-up is more common and is taken more seriously b/c estimating the “big-picture” numbers is almost impossible.

Question 61

Walk me through how you project expenses for a company.

Answer 61

• The simplest method is to make each I/S expense a percentage of revenue and hold it fairly constant‚ maybe decreasing the percentages slightly (due to economies of scale)‚ over time.
• For a more complex method‚ you could start w/ each department of a company‚ the number of employees in each‚ the average salary‚ bonuses‚ and benefits‚ and then make assumptions for those going forward.
• Usually you assume that the number of employees is tied to revenue‚ and then you assume growth rates for salary‚ bonuses‚ benefits‚ and other metrics.
• COGS should be tied directly to Revenue and each “unit” sold should incur an expense.
• Other items such as rent‚ CapEx‚ and misc. expenses are linked to the company’s internal plans for building expansion plans (if they have them)‚ or to Revenue in a simpler model.

Question 62

How do you project Balance Sheet items like Accounts Receivable and Accrued Expenses over several years in a 3-statement model?

Answer 62

Normally you assume that these are percentages of revenue or expenses‚ under the assumption that they’re all linked to the I/S:
• A/R (% of Revenue)‚ Prepaid Expense (% of Operating Expense)‚ Inventory (% of COGS)‚ Deferred Revenue (% of Revenue)‚ A/P (% of Operating Expenses)‚ Accrued Expenses (% of Operating Expenses)
• Then you either carry the same percentages across in future years or assume slight increases or decreases depending on the company.
• You can also project these metrics using “days‚” e.g. Accounts Receivable Days = Accounts Receivable / Revenue * 365‚ assume that the days required to collect A/R stays relatively the same each year‚ and calculate the A/R number from that.

Question 63

How should you project Depreciation and Capital Expenditures?

Answer 63

You could use several different approaches here:
• Simplest: Make each one a % of revenue.
• Alternative: Make Depreciation a % of revenue‚ but for CapEx average several years of CapEx‚ or make it an absolute dollar change (e.g. it increases by $100 each year) or percentage change (it increases by 2% each year).
• Complex: Create a PP&E schedule‚ where you estimate the CapEx increase each year based on management’s plans‚ and then Depreciate existing PP&E using each asset’s useful life and the straight-line method; also Depreciate new CapEx right after it’s added‚ using the same approach.

Question 64

There’s usually a “simple” and “complex” way of projecting a company’s financial statements. Is there a real advantage to using the complex method? In other words‚ does it give us better numbers?

Answer 64

• In short‚ no. The complex methods give you similar numbers most of the time - you’re not using them to get “better” numbers‚ but rather to get better support for those numbers.
• If you just say‚ “Revenue grows by 10% per year‚” there isn’t much evidence to back up that claim. But if you create a bottoms-up revenue model by segment‚ then you can say‚ “The 10% growth is driven by a 5% price increase in this segment‚ a 10% increase in units sold here‚ 15% growth in units sold in this geography” and so on.

Question 65

What are examples of non-recurring charges we need to add back to a company’s EBIT / EBITDA when analyzing its financial statements?

Answer 65

• Restructuring Charges‚ Goodwill Impairment‚ Asset Write-Downs‚ Bad Debt Expenses‚ One-Time Legal Expenses‚ Disaster Expenses‚ Changes in Accounting Policies
• Note that to qualify as an “add-back” or “non-recurring” charge for EBITDA / EBIT purposes‚ it needs to affect Operating Income on the Income Statement. So if one of these charges is “below the line‚” then you do not add it back for the EBITDA / EBIT calculation.
• Also note that you DO add back D&A and sometimes SBC when calculating EBITDA‚ but that these are not “non-recurring charges” b/c all companies have them every year - they’re just non-cash charges.

Question 66

What’s the difference between capital leases and operating leases? How do they affect the statements?

Answer 66

• Operating Leases are used for short-term leasing of equipment and property‚ and do not involve ownership of anything. Operating lease expenses show up as Operating Expenses on the I/S and impact Operating Income‚ Pre-Tax Income‚ and NI.
• Capital Leases are used for longer-term items and give the lessee ownership rights; they Depreciate‚ incur Interest Expense‚ and are counted as Debt.
• A lease is a Capital Lease is any one of the following 4 conditions is true:
1. If there’s a transfer of ownership at the end of the term.
2. If there’s an option to purchase the asset at a “bargain price” at the end of the term.
3. If the term of the lease is greater than 75% of the useful life of the asset.
4. If the present value of the lease payments is greater than 90% of the asset’s fair market value.

Question 67

How doe Net Operating Losses (NOLs) affect a company’s 3 statements?

Answer 67

• The “quick and dirty” way: reduce the Taxable Income by the portion of the NOLs that you can use each year‚ apply the same tax rate‚ and then subtract that new Tax number from your old Pre-Tax Income number (which should stay the same). Then you can deduct whatever you used up from the NOL balance (which should be a part of the DTA line item).
• A more complex way to do this: create a book vs. cash tax schedule where you calculate the Taxable Income based on NOLs‚ and then look at what you would pay in taxes without the NOLs. Then you record the difference as an increase to the DTL on the B/S.
• This method reflects the fact that you’re saving on cash flow - since the DTL‚ a Liability‚ is rising - but correctly separates the NOL impact into book vs. cash taxes.

Question 68

What’s the difference between Tax Benefits from Stock-Based Compensation and Excess Tax Benefits from Stock-Based Compensation? How do they impact the statements?

Answer 68

• Tax Benefits simply record what the company has saved in taxes as a result of issuing Stock-Based Compensation (e.g. they issue $100 in SBC and have a 40% tax rate so they save $40 in taxes).
• Excess Tax Benefits are a portion of these normal Tax Benefits and represent the amount of taxes they’ve saved due to share price increases (i.e. the Stock-Based Compensation is worth more due to a share price increase since they announced plans to issue it).
• Neither one is a separate item on the I/S.
• On the SCF‚ Excess Tax Benefits are subtracted out of CFO and added to CFF‚ effectively “re-classifying” them. Basically you’re saying‚ “We’ve gotten some extra cash flow from our share price increasing‚ so let’s call it what it is: a financing activity.”
• Also on the SCF‚ you add back the Tax Benefits in CFO. You do that b/c you want them to accrue to APIC on the B/S. You’re saying‚ “In addition to the additional value we created w/t his stock/option issuance‚ we’ve also gotten some value from the tax savings‚ so let’s reflect that value along with the SBC itself under APIC.”

Question 69

Let’s say you’re creating quarterly projections for a company rather than annual projections. What’s the best way to project revenue growth each quarter?

Answer 69

• It’s best to split out the historical data by quarters and then to analyze the Year-over-Year (YoY) Growth for each quarter. For example‚ in Q1 of Year 2 you would look at how much the company has grown revenue by in Q1 of previous years.
• It wouldn’t make much sense to use Quarter-over-Quarter growth (i.e. Q1 over Q4 in the previous year) b/c many companies are seasonal.
• The same applies for expenses as well: always make sure you take into account seasonality w/ quarterly projections.

Question 70

What’s the purpose of calendarizing financial figures?

Answer 70

• “Calendarizing” means “Rather than using a company’s normal fiscal year figures‚ let’s use another year-long period during the year and calculate their revenue‚ expenses‚ and other key metrics for that period.
• For example‚ a company’s fiscal year might end on Dec. 31 - if you calendarized it‚ you might look at the period from Jun. 30 in the previous year to Jun. 30 of this year rather than the traditional Jan. 1 - Dec. 31 period.
• You do this most frequently w/ public comps b/c companies often have “misaligned” fiscal years. If one company’s year ends Dec. 31‚ another’s ends Jun. 30‚ and another’s ends Sep. 30‚ you need to adjust and use the same time period for all of them - otherwise‚ you’re comparing apples to oranges b/c the financial figures are all from different time periods.

Question 71

What happens to the Deferred Tax Asset / Deferred Tax Liability line item if we record accelerated Depreciation for tax purposes‚ but straight-line Depreciation for book purposes?

Answer 71

• If Depreciation is higher on the tax schedule in the first few years‚ the DTL will increase b/c you’re paying less in cash taxes initially and need to make up for it later.
• Then‚ as tax Depreciation switches and becomes lower in the later years‚ the DTL will decrease as you pay more in cash taxes and “make up for” the early tax savings.

Question 72

If you own over 50% but less than 100% of another company‚ what happens on the financial statements when you record the acquisition?

Answer 72

• This scenario refers to a Noncontrolling Interest (AKA Minority Interest): you consolidate all the financial statements and add 100% of the other company’s statements to your own.
• It’s similar to a 100% acquisition where you do the same thing‚ but you also create a new item on the Liabilities & Equity side called a Noncontrolling Interest to reflect the portion of the other company that you don’t own (e.g. if it’s worth $100 and you own 70%‚ you would list $30 here).
• Just like with normal acquisitions‚ you also wipe out the other company’s SE when you combine its statement with yours‚ and you still allocate the purchase price.
• You also subtract NI Attributable to Noncontrolling Interests on the I/S - in other words‚ the other company’s Net Income * Percentage You Do Not Own. But then you add it back on the SCF in the CFO section. That is just an accounting rule and has no cash impact.
• On the B/S‚ the Noncontrolling Interest line item increases by that number (NI Attributable to Noncontrolling Interests) each year. RE decreases by that same number each year b/c it reduces NI‚ so the B/S remains in balance.

Question 73

What about if you own between 20% and 50% of another company? How do you record this acquisition and how are the statements affected?

Answer 73

• This case refers to an Equity Interest (AKA Associate Company) - here you do NOT consolidate the statements at all.
• Instead you reflect Percentage of Other Company That You Own * Value of Other Company and show it as an Asset on the B/S (Investments in Equity Interests). For example‚ if the other company is worth $200 and you own 30% of it‚ you record $60 for the Investments in Equity Interests line item.
• You also add Other Company’s NI * Percentage Ownership to your own NI on the I/S‚ and then subtract it on the SCF b/c it’s a non-cash addition.
• Each year‚ the Investments in Equity Interests line item increases by that number‚ and it decreases by any dividends issued from that other company to you. On the other side‚ RE will also change based on the change in NI‚ so everything balances.

Question 74

What if you own less than 20% of another company?

Answer 74

• This is where it gets inconsistent. Some companies may still apply the Equity Interest treatment in this case‚ especially if they exert “significant influence” over the other company.
• But sometimes they may also classify it as a simple Investment or Security on the B/S‚ acting as if they have simply bought a stock or bond and ignoring the other company’s financials.

Question 75

What are the different classifications for Securities that a company can use on its Balance Sheet? How do they differ?

Answer 75

• TRADING: These securities are very short-term and you count all Gains and Losses on the I/S‚ even if they’re unrealized (i.e. you haven’t sold the Securities yet).
• AVAILABLE FOR SALE (AFS): These Securities are longer-term and you don’t report Gains and Losses on the I/S - they appear under Accumulated Other Comprehensive Income (AOCI). The B/S values of these Securities also change over time b/c you mark them to market.
• HELD-TO-MATURITY (HTM): These Securities are even longer-term‚ and you don’t report unrealized Gains or Losses anywhere. Gains and Losses are only reported when they’re actually sold.

Question 76

• You own 70% of a company that generates Net Income of $10. Everything above Net Income on your Income Statement has already been consolidated.
• Walk me through how you would recognize Net income Attributable to Noncontrolling Interests‚ and how it affects the 3 statements.

Answer 76

• I/S: You show a line item for “NI Attributable to Noncontrolling Interests” near the bottom. You subtract $3 (Other Company Net Income of $10 * 30% You Don’t Own) to reflect the 30% of the other company’s NI that does not “belong” to you. At the bottom of the I/S‚ the “NI Attributable to Parent” line item is down by $3.
• SCF: NI is down by $3 as a result‚ but you add back this same charge b/c you do‚ in fact‚ receive this NI in cash when you own over 50% of the other company. So cash at the bottom of the SCF is unchanged.
• B/S: There are no changes on the Assets side. On the other side‚ the Noncontrolling Interests line item (included in SE) is up by $3 due to this NI‚ but RE is down by $3 b/c of the reduced NI at the bottom of the I/S‚ so this side doesn’t change and the B/S remains in balance.

Question 77

• You own 70% of a company that generates Net Income of $10. Everything above Net Income on your Income Statement has already been consolidated.
• Assume that this other company issues Dividends of $5‚ walk me through how that’s recorded on the statements.

Answer 77

• I/S: There are no changes b/c Dividends never show up on the I/S.
• SCF: There’s an additional Dividend of $5 under CFF on the SCF‚ so cash is down by $5.
• B/S: The Assets side is down by $5 as a result and SE (RE) is also down by $5.
• NOTE: Remember that the other company’s financial statements are consolidated w/ your own when you own over 50% - you only split out NI separately. So there’s no need to multiply by ownership percentages or anything when factoring in the impact of Dividends‚ or really any item other than NI.

Question 78

• You own 30% of another company that earns a Net Income of $20.
• Walk me through the 3 statements after you record the portion of Net Income that you’re entitled to.

Answer 78

Here‚ nothing has been consolidated b/c we own less than 50% of the other company. So nothing on the statements yet reflects this other company.
• I/S: We create an item “NI from Equity Interests” (or something similar) below our normal NI at the bottom‚ which results in our REAL NI (NI Attributable to Parent) increasing by $6 ($20 * 30%).
• SCF: NI is up by $6‚ but we subtract this $6 of additional NI b/c we haven’t really received it in cash when we own less than 50% - it’s not as if we control the other company and can just “take it.” Cash remains unchanged.
• B/S: The Investments in Equity Interests item on the Assets side increases by $6 to reflect this NI‚ so the Assets side is up by $6. On the other side‚ SE (RE) is up by $6 to reflect this increased NI‚ so both sides balance.

Question 79

• You own 30% of another company that earns a Net Income of $20. Assume that this 30% owned company issues Dividends of $10.
• Walk me through the 3 statements and explain what’s different prior to dividend issuance and afterwards.

Answer 79

• I/S: It’s the same: NI is up by $6 at the bottom.
• SCF: NI is up by $6 and we then subtract out the $6 that’s attributable to the Equity Interests. And then we add $3 ($10 * 30%) in the CFO Section to reflect the Dividends that we receive from these Equity Interests. So cash at the bottom is up by $3.
• B/S: Cash is up by $3 on the Assets side‚ and the Investments in Equity Interests line item is up by $6‚ but it falls by $3 due to those Dividends‚ so the Assets side is up by $6 total. On the other side‚ NI is up by $6 so SE (RE) is up by $6 and both sides balance.
• NOTE: The Investments in Equity Interests line item is like a “mini-SE” for companies that you own less than 50% of - you add however much NI you can “claim‚” and then subtract out your portion of the Dividends.
• Remember that only the Dividends of the parent company itself issues show up in the CFF section - Dividends received from other companies (such as what you see in this example) do not.

Question 80

• What if you only own 10% of another company (instead of 30%) that earns a Net Income of $20.
• Would anything change based on these different assumptions?

Answer 80

• In theory‚ yes‚ b/c when you own less than 20%‚ the other company should be recorded as a Security or Short-Term Investment and you would only factor in the Dividends received but not the NI from the Other Company.
• In practice‚ however‚ treatment varies and some companies may actually record this scenario the same way‚ especially if they exert “significant influence” over the 10% owned company.

Question 81

Walk me through what happens when you pay $20 interest on Debt‚ with $10 in the form of cash interest and $10 in the form of Paid-In-Kind (PIK) interest.

Answer 81

• I/S: Both forms of interest appear‚ so Pre-Tax Income falls by $20 and NI falls by $12 at a 40% tax rate.
• SCF: NI is down by $12‚ but you add back the $10 in PIK interest since it’s non-cash‚ so CFO is down by $2. Cash at the bottom is also down by $2 as a result.
• B/S: Cash is down by $2‚ so the Assets side is down by $2. On the other side‚ Debt increases by $10 b/c PIK Interest accrues to Debt‚ but SE (RE) falls by $12 due to the reduced NI‚ so this side is also down by $2 and both sides balance.
• NOTE: PIK Interest is just like any other non-cash charge: it reduces taxes but must affect something on the B/S - in this case‚ that’s the existing Debt number.

Question 82

• Due to a high issuance of Stock-Based Compensation and a fluctuating stock price‚ a company has recorded a significant amount of Tax Benefits from Stock-Based Compensation and Excess Tax Benefits from Stock-Based Compensation.
• Assume that it records $100 in Tax Benefits from SBC‚ with $40 of Excess Tax Benefits from SBC‚ and walk me through the 3 statements. Ignore the original Stock-Based Compensation issuance.

Answer 82

• I/S: No changes.
• SCF: You add back the $100 in Tax Benefits from SBC in CFO and subtract out the $40 in Excess Tax Benefits‚ so CFO is up by $60. Then under CFF‚ you add back the $40 in Excess Tax Benefits‚ so Cash at the bottom is up by $100.
• B/S: Cash is up by $100‚ so the Assets side is up by $100. On the other side‚ Common Stock & APIC is up by $100 b/c Tax Benefits from SBC flow directly into there.
• The Rationale: Essentially we’re “reclassifying” the Tax Benefits OUT of CFO and saying that they should accrue to a company’s SE. And we are also saying that Excess Tax Benefits (which arise due to share price increases) should be counted as a Financing activity but should NOT impact cash‚ since they’re already a part of the normal Tax Benefits.

Question 83

• A company records Book Depreciation of $10 per year for 3 years. On its Tax financial statements‚ it records Depreciation of $15 in Year 1‚ $10 in Year 2‚ and $5 in Year 3.
• Walk me through what happens on the BOOK financial statements in Year 1.

Answer 83

• I/S: On the Book I/S you list the Book Depreciation number‚ so Pre-Tax Income falls by $10 and NI falls by $6 with a 40% tax rate. On the Tax I/S‚ Depreciation was $15 so NI fell by $9 rather than $6. Taxes fell by $2 more on the Tax version (assume that prior to the changes‚ Pre-Tax Income was $100 and Taxes were $4. Book Pre-Tax income afterward was therefore $90 and Tax Pre-Tax Income was $85. Book Taxes were $36 and Cash Taxes were $34‚ so Book Taxes fell by $4 and Cash Taxes fell by $6).
• SCF: On the Book Cash Flow Statement‚ NI is down by $6‚ but you add back the Depreciation of $10 and you add back $2 worth of Deferred Taxes - that represents the fact that Cash Taxes were lower than Book Taxes in Year 1. At the bottom‚ Cash is up by $6.
• B/S: Cash is up by $6 but PP&E is down by $10 due to the Depreciation‚ so the Assets side is down by $4. On the other side‚ the DTL increases by $2 due to the Book/Cash Tax difference‚ but SE (RE) is down by $6 due to the lower NI‚ so both sides are down by $4 and balance.

Question 84

• A company records Book Depreciation of $10 per year for 3 years. On its Tax financial statements‚ it records Depreciation of $15 in Year 1‚ $10 in Year 2‚ and $5 in Year 3.
• Walk me through what happens on the BOOK financial statements in Year 2.

Answer 84

This one’s easy b/c now Book and Tax Depreciation are the same.
• I/S: Pre-Tax Income is down by $10‚ so NI falls by $6.
• SCF: NI is down by $6 and you add back the $10 of Depreciation on the SCF‚ but there are no changes to Deferred Taxes b/c Book Depreciation = Tax Depreciation and therefore Book Taxes = Cash Taxes this year. Cash at the bottom increases by $4.
• B/S: Cash is up by $4 but PP&E is down by $10‚ so the Assets side is down by $6. The other side is also down by $6 b/c SE (RE) is lower due the reduced NI.

Question 85

• A company records Book Depreciation of $10 per year for 3 years. On its Tax financial statements‚ it records Depreciation of $15 in Year 1‚ $10 in Year 2‚ and $5 in Year 3.
• Walk me through what happens on the BOOK financial statements in Year 3.

Answer 85

• I/S: On the Book I/S‚ you use the Book Depreciation number so Pre-Tax Income falls by $10 and NI falls by $6 with a 40% tax rate. On the Tax I/S‚ Depreciation was $5 so NI fell by $3 rather than $6. Taxes fell by $2 more on the Tax version (assume that prior to the changes‚ Pre-Tax Income was $100 and Taxes were $40. Book Pre-Tax Income afterward was therefore $90 and Tax Pre-Tax Income was $95. Book Taxes were $36 and Cash Taxes were $38‚ so Book Taxes fell by $4 and Cash Taxes fell by $2).
• SCF: On the Book SCF‚ NI is down by $6‚ but you add back the Depreciation of $10 and you subtract out $2 worth of additional Cash Taxes - that represents the fact that Cash Taxes were higher than Book Taxes in Year 1 (meaning that you’re now paying extra to make “catch-up payments.” At the bottom‚ Cash is up by $2.
• B/S: Cash is up by $2‚ but PP&E is down by $10 due to the Depreciation‚ so the Assets side is down by $8. On the other side‚ the DTL decreases by $2 due to the Book/Cash Tax difference and SE (RE) is down by $6 due to the reduced NI‚ so both sides are down by $8 and balance.

Question 86

A company you’re analyzing records a Goodwill Impairment of $100. However‚ this Goodwill Impairment is NOT deductible for cash tax purposes. Walk me through how the 3 statements change.

Answer 86

• I/S: You still reduce Pre-Tax Income by $100 due to the Impairment‚ so NI falls by $60 at a 40% tax rate - when it’s not tax-deductible‚ you make that adjustment via DTLs or DTAs. On the Tax I/S‚ Pre-Tax Income has not fallen at all and so NI stays the same‚ which means that Cash Taxes are $40 higher than Book Taxes.
• SCF: NI is down by $60‚ but we add back the $100 Impairment since it is non-cash. Then we also subtract $40 from Deferred Taxes b/c Cash Taxes were higher than Book Taxes by $40 - meaning that we’ll save some cash (on paper) from reduced Book Income Taxes in the future. Adding up all these changes‚ there are no net changes in Cash.
• B/S: Cash is the same‚ but Goodwill is down by $100 due to the Impairment‚ so the Assets side is down by $100. On the other side‚ the DTL is down by $40 and SE (RE) is down by $60 due to the reduced NI‚ so both sides are down by $100 and balance.
• Intuition: When a charge is not truly tax-deductible‚ a firm pays higher Cash Taxes and either “makes up for” owed future tax payments or gets to report lower Book Taxes in the future.
• Remember that DTLs get created when additional future cash taxes are owed - when additional future cash taxes are paid‚ DTLs decrease.

Question 87

How can you tell whether or not a Goodwill Impairment will be tax-deductible?

Answer 87

• There’s no way to know for sure unless the company states it‚ but generally Impairment on Goodwill from acquisitions is NOT deductible for tax purposes.
• If it were‚ companies would have a massive incentive to start writing down the values of their acquisitions and saving on taxes from non-cash charges‚ which the government wouldn’t like too much.
• Goodwill arising from other sources may be tax-deductible‚ but it’s rare to see significant Impairment charges unless they’re from acquisitions.

Question 88

• A company has Net Operating Losses (NOLs) of $100 included in the Deferred Tax Asset (DTA) line item on its Balance Sheet because it has been unprofitable up until this point.
• Now the company finally turns a profit and has Pre-Tax Income of $200 this year.
• Walk me through the 3 statements and assume that the NOLs can be used as a direct tax deduction on the financial statements.

Answer 88

• I/S: The company can apply the entire NOL balance to offset its Pre-Tax Income‚ so Pre-Tax Income falls by $100 and NI falls by $60 at a 40% tax rate.
• SCF: NI is down by $60 but the company hasn’t truly lost anything - it has just saved on taxes. So you add back this use of NOLs and label it “deferred taxes” - it should be a positive $100‚ which means that Cash at the bottom is up $40.
• B/S: Cash is up by $40 and the DTA is down by $100‚ so the Assets side is down by $60. On the other side‚ SE (RE) is down by $60 due to the reduced NI‚ so both sides balance.

Question 89

• You’re analyzing a company’s financial statements and you need to calendarize the revenue‚ EBITDA‚ and other items.
• The company earned revenue of $1000 and EBITDA of $200 from Jan. 1 to Dec. 31‚ 2050.
• From Jan. 1 to Mar. 31‚ 2050‚ it earned revenue of $200 and EBITDA of $50.
• From Jan. 1 to Mar. 31‚ 2051‚ it earned revenue of $300 and EBITDA of $75.
• What are the company’s revenue and EBITDA for the Trailing Twelve Months as of Mar. 31‚ 2051?

Answer 89

• Trailing Twelve Months (TTM) = New Partial Period + Twelve-Month Period - Old Partial Period

So in this case:
• TTM Revenue = $300 + $1000 - $200 = $1100
• TTM EBITDA = $75 + $200 - $50 = $225

Question 90

• A company acquires another company for $1000 using 50% stock and 50% cash. The other company has Assets of $1000 and Liabilities of $800.
• Using that information‚ combine the companies’ financial statements and walk me through what the Balance Sheet looks like IMMEDIATELY after the acquisition.

Answer 90

• The acquirer has used $500 of cash and $500 of stock to acquire the seller‚ and the seller’s Assets are worth $1000‚ with Liabilities of $800 and therefore Equity of $200.
• In an M&A deal‚ the Equity of the Seller gets wiped out completely. So you simply add the Seller’s Assets and Liabilities to the Acquirer’s - the Assets side is up by $1000 and the Liabilities side is up by $800.
• Then you subtract the cash used‚ so the Assets side is up by $500 only‚ and the other side is up by $1300 due to the $800 of Liabilities and the $500 stock issuance.
• Our B/S is out of balance‚ and that’s why we need Goodwill. Goodwill equals the Purchase Price minus the Seller’s Book Value‚ so in this case it’s equal to $1000 - $200 = $800.
• That $800 of Goodwill gets created on the Assets side‚ and so both sides are now up by $1300 and the B/S balances.

Question 91

• You’re analyzing a company with $100 in Short-Term Investments on its Balance Sheet. These Investments are classified as Available-for-Sale (AFS) Securities.
• The market value for these securities increases to $110.
• Walk me through what happens on the 3 statements.

Answer 91

• I/S: Since these are AFS Securities‚ you do NOT report unrealized Gains and Losses on the I/S. There are no changes.
• SCF: There are no changes b/c no cash accounts change.
• B/S: The Short-Term Investments line item increases by $10 on the Assets side and Accumulated Other Comprehensive Income (AOCI) increases by $10 on the other side under SE‚ so the B/S balances.

Question 92

• You’re analyzing a company with $100 in Short-Term Investments on its Balance Sheet. These Investments are classified as Trading Securities.
• The market value for these securities increases to $110.
• Walk me through what happens on the 3 statements.

Answer 92

With Trading Securities‚ you DO show Unrealized Gains and Losses on the I/S.
• I/S: Both Operating Income and Pre-Tax Income increase by $10‚ and so NI increases by $6 at a 40% tax rate.
• SCF: NI is up by $6‚ but you subtract the Unrealized Gain of $10 b/c it’s non-cash‚ so Cash at the bottom is down by $4.
• B/S: Cash is down by $4 on the Assets side and Short-Term Investments is up by $10‚ so the Assets side is up by $6 overall. On the other side‚ SE (RE) is up by $6 due to the increased NI.
• Intuition: We’ve paid taxes on a non-cash source of income‚ so cash is down. However‚ the paper value of our Assets has increased.