Accounting Flashcards
What is a deferred tax liability and why might one be created?
Deferred tax liability is a tax expense amount reported on a company’s income statement that is not actually paid to the IRS in that time period, but is expected to be paid in the future. It arises because when a company actually pays less in taxes to the IRS than they show as an expense on their income statement in a reporting period.
Differences in depreciation expense between book reporting (GAAP) and IRS reporting can lead to differences in income between the two, which ultimately leads to differences in tax expense reported in the financial statements and taxes payable to the IRS.
Why do capital expenditures increase assets (PP&E), while other cash outflows, like paying salary, taxes, etc., do not create any asset, and instead instantly create an expense on the income statement that reduces equity via retained earnings?
Capital expenditures are capitalized because of the timing of their estimated benefits – the lemonade stand will benefit the firm for many years. The employees’ work, on the other hand, benefits the period in which the wages are generated only and should be expensed then. This is what differentiates an asset from an expense.
How could a company to show positive net income and still go bankrupt?
Two examples include deterioration of working capital and improper financial accounting techniques (Enron).
If a company purchases a large piece of equipment, how does it affect each of the 3 financial statements?
- Initially, there is no impact (income statement); cash goes down, while PP&E goes up (balance sheet), and the purchase of PP&E is a cash outflow (cash flow statement).
- Over the life of the asset: depreciation reduces net income (income statement); PP&E goes down by depreciation, while retained earnings go down (balance sheet); and depreciation is added back (because it is a non-cash expense that reduced net income) in the cash from operations section (cash flow statement).
What is a 10K?
The 10-K includes a written synopsis of the company’s strategy and results for a given fiscal year. It includes a letter to shareholders, management information and compensation, management discussions, and an auditor’s statement. It also includes detailed financial statements for the fiscal year, including a Balance Sheet, Income Statement, and Cash Flow Statement.
What is a 10Q?
The 10-Q is a boiled-down 10-K. It must be filed by a public company for each fiscal quarter. The 10-Q focuses mainly on financial statements and includes less narrative information.
What are the three main financial statements?
- Income Statement
- Revenues - COGS - Expenses = Net Income
- Balance Sheet
- Assets = Liabilities + Equity
- Statement of Cash Flows
- Beginning Cash + Cash from Operations + Cash from Investing + Cash from Financing = Ending Cash
How are the three main financial statements connected?
- There are many connections between the three financial statements, here are a few of the most common:
- Income Statement
- Net income is the beginning point for the Cash Flow statement.
- Interest expense on the Income Statement is calculated from the debt on the Balance Sheet.
- Depreciation and Amortization is calculated based on property, plant, and equipment (PP&E) from the Balance Sheet. A $10 increase in depreciation expense will result in a $10 reduction in net PP&E and a $10 x (1-T) in net income.
- Net income minus dividends paid = addition to retained earnings on the Balance Sheet.
- Cash Flow Statement
- Organized into Cash Flow from Operations, Investing, and Financing.
- Net income is the one of the first lines and comes from the Income Statement.
- Adjust for non-cash items (like Depreciation and Amortization) from the Income Statement.
- Adjust for change in working capital, which is calculated from changes in current assets and current liabilities on the Balance Sheet.
- One of the final lines will be change in cash. Beginning cash (which comes from prior period’s Balance Sheet) plus change in cash yields ending cash balance on the current period’s Balance Sheet.
- Balance Sheet
- Debt is affected by Cash Flow from financing, which would include any mandatory amortization of debt, optional amortization, repayments, new debt issuance, etc.
- Cash balance is determined from the Cash Flow statement as described above.
- Assets like PP&E and goodwill are reduced in value by depreciation and amortization.
- Retained earnings is increased/decreased by net income minus dividends paid as described above
Walk me through the major line items on an income statement
The first line of the Income Statement represents revenues or sales. From that you subtract the cost of goods sold, which leaves gross margin. Subtracting operating expenses from gross margin gives you operating income. From operating income you subtract interest expense and any other expenses (or add other income), such as tax payments or interest earnings, and what’s left is net income.
What are the three components of the Statement of Cash Flows?
Cash from Operations – Cash generated or lost through normal operations, sales, and changes in working capital (more detail on working capital below).
Cash from Investing – Cash generated or spent on investing activities; may include, for example, capital expenditures (use of cash) or asset sales (source of cash). This section will also show any investments in the financial markets and operating subsidiaries. Note: This section can explain a large negative cash flow during the reporting period, which isn’t necessarily a bad thing if it is due a large capital expenditure in preparation for future growth.
Cash from Financing - Cash generated or spent on financing the business; may include proceeds from debt or equity issuance (source of cash) or cost of debt or equity repurchase (use of cash).
If you could use only one financial statement to evaluate the financial state of a company, which would you choose?
I would want to see the Cash Flow Statement so I could see the actual liquidity position of the business and how much cash it is using and generating. The Income Statement can be misleading due to any number of non-cash expenses that may not truly be affecting the overall business. And the Balance Sheet alone just shows a snapshot of the Company at one point in time, without showing how operations are actually performing. But whether a company has a healthy cash balance and generates significant cash flow indicates whether it is probably financially stable, and this is what the CF Statement would show.
What is the difference between the Income Statement and Statement of Cash Flows?
A company’s sales and expenses are recorded on its Income Statement. The Statement of Cash Flows records what cash is actually being used during the reporting period and where it is being spent. Other items included on the Cash Flow Statement could be issuance or repurchase of debt or equity and capital expenditures or other investments. Amortization and depreciation will be reflected as expenses on the Income Statement, but they will be added back to net income on the Cash Flow Statement since they are expenses but not actually a use of cash.
What is the link between the Balance Sheet and the Income Statement?
There are many links between the Balance Sheet and the Income Statement. The major link is that any net income from the Income Statement, after the payment of any dividends, is added to retained earnings. In addition, debt on the Balance Sheet is used to calculate the interest expense on the Income Statement, and property plant and equipment will be used to calculate any depreciation expense.
What is the link between the Balance Sheet and the Statement of Cash Flows?
Beginning cash on the Statement of Cash Flows comes from the previous period’s Balance Sheet. Cash from operations on the Cash Flow Statement is affected by the Balance Sheet’s numbers for change in net working capital, current assets minus current liabilities. Property, plant, and equipment is another Balance Sheet item that affects the Cash Flow Statement because depreciation is based on the amount of PP&E a company has. Any change due to purchase or sale of property, plant, and equipment will affect cash from investing. Finally the Cash Flow Statement’s ending cash balance becomes the beginning cash balance on the new Balance Sheet.
What is EBITDA?
EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a good high-level indicator of a company’s financial performance. Since it removes the effects of financing and accounting decisions such as interest and depreciation, it’s a good way to compare the performance of different companies. It serves as a rough estimate of free cash flow, and is used in the EV/EBITDA multiple to quickly establish a company’s high-level valuation.
