Accounting Flashcards
Walk me through the 3 financial statements
The 3 major financial statements are the Income Statement, Balance Sheet and Cash Flow Statement.
The Income Statement shows the company’s revenue and expenses over a period of time, and goes down to Net Income, the final line on the statement.
The Balance Sheet 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 – at a specific point in time. Assets must equal Liabilities plus Shareholders’ Equity.
The Cash Flow Statement begins with Net Income, adjusts for non-cash expenses and changes in operating assets and liabilities (working capital), and then shows how the company has spent cash or received cash from Investing or Financing activities; at the end, you see the company’s net change in cash.
Can you give examples of major line items on each of the financial statements?
Income Statement: Revenue; Cost of Goods Sold; SG&A (Selling, General & Administrative) Expenses; Operating Income; Pre-Tax Income; Net Income.
Balance Sheet: Cash; Accounts Receivable; Inventory; Plants, Property & Equipment (PP&E); Accounts Payable; Accrued Expenses; Debt; Shareholders’ Equity.
Cash Flow Statement: Cash Flow from Operations (Net Income; Depreciation & Amortization; Stock-Based Compensation; Changes in Operating Assets & Liabilities); Cash Flow from Investing (Capital Expenditures, Sale of PP&E, Sale/Purchase of Investments); Cash Flow from Financing (Dividends Issued, Debt Raised / Paid Off, Shares Issued / Repurchased)
How do the 3 statements link together?
To tie the statements together, Net Income from the Income Statement becomes the top line of the Cash Flow Statement.
Then, you add back any non-cash charges such as Depreciation & Amortization to this Net Income number.
Next, changes to operational Balance Sheet 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 Cash Flow from Operations.
Now you take into account investing and financing activities and changes to items like PP&E and Debt on the Balance Sheet; those will increase or decrease cash flow, and at the bottom you get the net change in cash.
On the Balance Sheet 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 Cash Flow Statement.
On the other side, Net Income flows into Shareholders’ Equity to make the Balance Sheet balance.
At the end, Assets must always equal Liabilities plus Equity.
If I were stranded on a desert island and only had one financial statement and I wanted to review the overall health of a company, which statement would I use and why?
You would use the Cash Flow Statement because it gives a true picture of how much cash the company is actually generating – the Income Statement is misleading because it includes non-cash expenses and excludes actual cash expenses such as Capital Expenditures.
And that’s the #1 thing you care about when analyzing the financial health of any business – its true cash flow.
Let’s say I could only look at 2 statements to assess a company’s prospects – which 2 would I use and why?
You would pick the Income Statement and Balance Sheet because you can create the Cash Flow Statement from both of those (assuming that you have “Beginning” and “Ending” Balance Sheets that correspond to the same period the Income Statement is tracking).
Let’s say I have a new, unknown item that belongs on the Balance Sheet. How can I tell whether it should be an Asset or a Liability?
An Asset will result in additional cash or potential cash in the future – think about how Investments or Accounts Receivable 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 Accounts Payable will result in a direct cash decrease, and how something like Deferred Revenue will result in an indirect cash decrease as you recognize additional taxes in the future from recognizing revenue.
Ask what direction cash will move in as a result of this new item and that tells you whether it’s an Asset or Liability.
How can you tell whether or not an expense should appear on the Income Statement?
Two conditions MUST be true for an expense to appear on the IS:
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 because it is not tax-deductible.
Advanced Note: Technically, “tax-deductible” here means “deductible for book tax purposes” (i.e. only the tax number that appears on the company’s Income Statement) – see the Advanced Accounting section for more on this topic.
Let’s say that you have a non-cash expense (Depreciation or Amortization, for example) on the Income Statement. Why do you add back the entire expense on the Cash Flow Statement?
Because you want to reflect that you’ve saved on taxes with the non-cash expense.
Let’s say you have a non-cash expense of $10 and a tax rate of 40%. Your Net Income decreases by $6 as a result… but then you add back the entire non-cash expense of $10 on the CFS 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 our taxes or cash balance.
How do you decide when to capitalize rather than expense a purchase?
If the purchase corresponds to an Asset with a useful life of over 1 year, it is capitalized (put on the Balance Sheet rather than shown as an expense on the Income Statement). 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 Balance Sheet. Employee salaries and the cost of manufacturing products (COGS) only “last” for the current period and therefore show up on the Income Statement as normal expenses instead.
Note that even if you’re paying for something like a multi-year lease for a building, you would not capitalize it unless you own the building and pay for the entire building in advance.
If Depreciation is a non-cash expense, why does it affect the cash balance?
Although Depreciation is a non-cash expense, it is tax-deductible. Therefore, an increase in Depreciation will reduce the amount of taxes you pay, which boosts your cash balance. The opposite happens if Depreciation decreases.
Where does Depreciation usually appear on the Income Statement
It could be in a separate line item, or it could be embedded in Cost of Goods Sold or Operating Expenses – each company does it differently. Note that the end result for accounting questions is the same: Depreciation always reduces Pre-Tax Income.
Why is the Income Statement not affected by Inventory purchases?
The expense of purchasing Inventory is only recorded on the Income Statement when the goods associated with it have been manufactured and sold – so if it’s just sitting in a warehouse, it does not count as Cost of Goods Sold (COGS) until the company manufactures it into a product and sells it.
Debt repayment shows up in Cash Flow from Financing on the Cash Flow Statement. Why don’t interest payments also show up there? They’re a financing activity!
The difference is that interest payments correspond to the current period and are tax-deductible, so they have already appeared on the Income Statement. Since they are a true cash expense and already appeared on the IS, showing them on the CFS would be double-counting them and would be incorrect.
Debt repayments are a true cash expense but they do not appear on the IS, so we need to adjust for them on the CFS.
If something is a true cash expense and it has already appeared on the IS, it will never appear on the CFS unless we are re-classifying it – because you have already factored in its cash impact.
What’s the difference between Accounts Payable and Accrued Expenses?
Mechanically, they are the same: they’re Liabilities on the Balance Sheet used when you’ve recorded an Income Statement 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 (see the model).
The difference is that Accounts Payable 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, rent, and utilities.
When would a company collect cash from a customer and not record it as revenue?
Typically this happens when the customer pays upfront, in cash, for months or years of a product/service, but the company hasn’t delivered it yet. Cases where you see this:
1. Web-based subscription software.
2. Cell phone carriers that sell annual contracts.
3. 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
