ACCOUNTING

Question 1

If accounts receivable decreases from one year to the next, is that positive or negative working capital?

Answer 1

accounts receivable – so a decrease in accounts receivable means that you’re gaining money, which means it’s a source of cash. And an increase in source of cash means a decrease in working capital. We could also go off of it from the definition of working capital, which is current assets minus current liabilities. Accounts receivable being a current asset, it going down means that working capital also goes down.

Question 2

If you were looking at a company that had a high accounts receivable balance, would that concern you? What questions would that raise?

Answer 2

I would actually look at the trend of accounts receivable through its past, and if I found that accounts receivable is pretty much steady, I wouldn’t pay much attention to it because maybe that is how its customer supply chain, customer relationships work. But if I do find a sort of uptick, it perhaps signals its customers are having some trouble paying off the money that is owed to you, even after you give them the product, and there’s definitely a lot of room for operational efficiency changes there if you choose to take over the company.

Question 3

Discuss the impact of using LIFO versus FIFO in an inflationary environment.

Answer 3

So in an inflationary environment, the cost of goods would be increasing, so in a last-in, first-out, the cost of goods closer in the present day will be a lot higher than the cost of goods later on. And this will affect your net income. For example, your net income in this closer day will be lower than that of in the future. And it’s opposite for FIFO where your net income in the current day would be a lot higher than that one in the future. And this affects valuation because of the time value of money. If you’re earning less money today than you are tomorrow, that would give you a lower valuation than if you’re making more money today than tomorrow.

Question 4

If accounts receivable decreases from one year to the next, is that positive or negative, uh, working capital?

Answer 4

I think it’s helpful here to think about what working capital is and that’s current assets less current liabilities. Accounts receivable are current asset, so all else held equal, if you’re over a year accounts receivable decreases, then working capital would also decrease.

Question 5

How do the three statements link together? Assume the indirect method for the cash flow statement.

Answer 5

Net income will flow into retained earnings and also to the top of the cash flow statement. Then D&A will be taken out of PP&E on the balance sheet and added back on the cash flow statement. CAPEX will hit your cash flow statement but then will be added back to PP&E in the balance sheet. And then, um, cash at the bottom of the cash flow statement will be added to the assets side of the balance sheet. Uh, and then any changes in working capital will be reflected in the cash flow statement as well.

Question 6

Your company sells a yearly subscription for $120. Walk me through the impact that this sale has on the financial statements.

Answer 6

debit Subscriptions Expense for $120 and credit Cash for $120 at the time of entering the invoice into the accounting records.

Question 7

What is the difference between gross revenue and net revenue?

Answer 7

Easy. Gross revenue is your earnings before you deduct your expenses and your net revenue is your earnings after you subtract your expenses.

Question 8

You misstated depreciation in your model. It should be $10 million higher. How does this affect the three financial statements?

Answer 8

Beginning with the IS, depreciation expense is now $10 million higher. Assuming a 40 percent tax rate, net income is $6 million lower. Depreciation is non-cash and you inherit a tax benefit; on the CFS, you add back the $10 million, which results in a $4 million (-$6 million net income + $10 million depreciation expense) increase in cash. This cash increase of $4 million flows into the BS under the assets, on the left side. Also, PP&E decreases by the depreciation of $10 million, so total assets went down by $6 million. To balance, the $6 million decrease in net income impacts your shareholders equity on the right side.

Question 9

You sold an asset where you received $500 million in cash. How does this affect your three financial statements?

Answer 9

The key to this question is inquiring about the book value of the asset when sold. Ask the interviewer for this. For instance, if it is $400 million, then a $100 gain on sale of asset is recorded. Assuming a 40 percent tax rate, net income increases by $60 million. On the CFS, remember that assets are recorded at book value when sold. Therefore, you have a $400 million “sale of asset” under cash from investing activities. Your net cash flow is $460 million. On the BS, cash increases by $460 million and PP&E decreases by $400 million. The $60 million increase on the left side of the BS is offsest by the $60 million increase in shareholder’s equity on the right side.

Question 10

List the line items in the cash flow statement.

Answer 10

The CFS is broken up into three sections: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. In cash flow from operating, the key items are net income, depreciation and amortization, equity in earnings, non-cash stock compensation, deferred taxes, changes in working capital and changes in other assets and liabilities. In cash flow from investing, the key items are capital expenditures and asset sales. In cash flow from financing, the key items are debt raised and paid down, equity raised, share repurchases and dividends.

Question 11

If you merge two companies, what does the pro-forma income statement look like? Discuss whether you can just add each line item for the proforma company. Please start from the top.

Answer 11

Revenues and operational expenses can be added together, plus any synergies.
Fixed costs tend to have more potential synergies than variable costs. Selling,
general and administrative (“SG&A”) expense is another source of synergy, as
you only need one management to lead the two merged companies. D&A will
increase more than the sum due to financing fees and assets being written up. This brings you to operating income. Any changes in cash will affect your interest income. Interest expense will change based on the new capital structure. New or refinanced debt will change pro-forma interest expense. For rolled over debt, since your cash flows will change, your debt paydown may alter, which also affects interest. Based on all the changes previously, this will obviously cause taxes to differ so you cannot just add the two old tax amounts. Also, if any NOLs are gained, those may offset the new combined taxable income. To summarize, nothing can be simply added together. If you have done EPS accretion/dilution analysis, you can mentally work your way through that to formulate your answer.

Question 12

If you could have only one of the three main financial statements, which would it be?

Answer 12

The IS is definitely inappropriate to pick. Income statements are full of non-cash items, which work fine for theoretical purposes, like matching revenue to expenses in appropriate time periods, but if none of it could be liquidated then company is worth nothing. Most pick CFS, because cash is king in determining a company’s health. One interviewer selected BS because you can back out the main components of the cash flow statement (capex via PP&E and depreciation, net income via retained earnings, etc.). The BS is also helpful in distressed situations to determine the company’s liquidation value.

Question 13

A pen costs $10 dollars to buy. It has a life of ten years. How would you put it on the balance sheet?

Answer 13

On the left side, $10 as an asset. Assuming a straight-line depreciation for book and no salvage value at the end of its useful life, it would be worth $9 at the end of the first year, $8 the second year, and so on. Net income will be lowered every year by the tax-affected depreciation, so shareholders’ equity will be reduced by 60 cents, assuming a 40 percent tax rate.

Question 14

At the end of the second year, you discover the pen is a rare collector’s item. How much is it on the balance sheet?

Answer 14

Still $8. You continue to depreciate it. Assets are recorded at historical values. Some traded financial instruments qualify for “mark to market accounting,” so those assets are valued at market, but this accounting practice has been severely criticized in recent times.

Question 15

In another scenario, at the end of the second year, the pen runs out of ink and you have to throw it away. How much is it on the balance sheet?

Answer 15

Since the pen is worthless, you’ll need to write down the value of this equipment to $0. Due to the write down, net income declines by $4.8 based on a 40 percent tax rate, which flows to shareholders’ equity. The $8 write-down is noncash; on the CFS, it is added to the $4.8 decline in net income, resulting in a net cash flow of $3.2. Combined with the write-down of $8 for PP&E, net change in assets is a decrease of $4.8, which balances the $4.8 decrease in shareholder’s equity.

Question 16

What is the link between the balance sheet and income statement?

Answer 16

The main link between the two is profits from the IS are added to the BS as
retained earnings. Next, the interest expense on the IS is charged on the debt
that is recorded on the BS. D&A is a capitalized expense from the IS that will
reduce the PP&E on the asset side of the BS.

Question 17

If a company has seasonal working capital, is that a deal killer?

Answer 17

Working capital (“WC”) is current assets less current liabilities. Seasonal working capital applies to firms whose business is tied to certain time periods. When current assets are higher than current liabilities, this means more cash is being tied up instead of being borrowed. For instance, UGG mostly manufactures snow boots. In the winter, demand is higher, so the firm must build up inventories to meet this demand at this time, increasing current assets. Since more cash is tied up, this can increase the liquidity risk. If UGGs suddenly go out of fashion, then the company is stuck holding the inventory. Also, if people frequently pay with credit for the company’s products, the amount is listed as accounts receivable (“AR”), which represents future profits but is noncash. Therefore, if the company cannot collect this owed cash in time to pay its creditors, it runs of the risk of bankruptcy. This is an issue to note and watch, but it is not a deal killer if you have an adequate revolver and can predict the seasonal WC requirements with some clarity. In general, any recurring event is fine as long as it continues to perform as planned. The one-time massive surprise event is what can kill an investment.

Question 18

If a company issues a PIK security, what impact will it have on the three statements?

Answer 18

PIK stands for “paid in kind,” another important non-cash item that refers to
interest or dividends paid by issuing more of the security instead of cash. This
can mean compounding profits for the lenders and flexibility for the borrower.
For instance, a mezzanine bond of $100 million and 10 percent PIK interest will be added to the BS as $100 million as debt on the right side, and cash on the left side. On the CFS, cash flow from financing will list an increase of $100 million as debt raised. When the PIK is triggered and all else is equal, interest on the IS will be increased by $10 million, which will reduce net income by $6 million (assuming a 40 percent tax rate). This carries over onto the CFS where net income decreases by $6 million and the $10 million of PIK interest is added back (since it is non-cash), resulting in a net cash flow of $4 million. On the BS, cash increases by $4 million, debt increases by $10 million (the PIK interest accretes on the balance sheet as debt) and shareholders equity decreases by $6 million.

Question 19

If I increase AR by $10mm, what effect does that have on cash? Explain what AR is in layman terms.

Answer 19

There is no immediate effect on cash. AR is account receivable, which means the company received an IOU from customers. They should pay for the product or service at a later point in time. There will be an increase in cash of $10 million when the company collects on the account receivable.

Question 20

Give examples of ways companies can manipulate earnings.

Answer 20

1) Switching from LIFO to FIFO or vice versa. In a rising cost environment,
switching to LIFO from FIFO will show lower earnings, higher costs and lower
taxes.
2) Switching from fair value to cash flow hedges. Changes in fair value hedges
are in earnings, changes in cash flow hedges are in other comprehensive
income. Having negative fair value hedges and then shifting them to cash
flow hedges will increase earnings. 3) Taking write-downs to inventory will decrease earnings.
4) Changing depreciation methods.
5) Having a more aggressive revenue recognition policy. Accounts receivable
will increase rapidly because they’re extending easier credit.
6) Capitalizing interest that shouldn’t be capitalized, so you decrease interest
expense on the income statement.
7) Manipulating pre-tax or after-tax gains.
8) Mark-to-market/Mark-to-model.

Question 21

Is goodwill depreciated?

Answer 21

Not anymore. Accounting rules now state that goodwill must be tested once per year for impairment. Otherwise, it remains on the BS at its historical value. Note that goodwill is an intangible asset that is created in an acquisition, which represents the value between price paid and value of the company acquired.

Question 22

What is a stock purchase and what is an asset purchase?

Answer 22

A stock purchase refers to the purchase of an entire company so that all the outstanding stock is transferred to the buyer. Effectively, the buyer takes the seller’s place as the owner of the business and will assume all assets and liabilities. In an asset deal, the seller retains ownership of the stock while the buyer uses a new or different entity to assume ownership over specified assets.

Question 23

Stock purchase or asset purchase……Which structure does the seller prefer and why? What about the buyer?

Answer 23

A stock deal generally favors the seller because of the tax advantage. An asset deal for a C corporation causes the seller to be double-taxed; once at the corporate level when the assets are sold, and again at the individual level when proceeds are distributed to the shareholders/owners. In contrast, a stock deal avoids the second tax because proceeds transfer directly to the seller. In non-C corporations like LLCs and partnerships, a stock purchase can help the seller pay transaction taxes at a lower capital gains rate (there is a capital gains and ordinary income tax difference at the individual level, but not at a corporate level). Furthermore, since a stock purchase transfers the entire entity, it allows the seller to completely extract itself from the business. A buyer prefers an asset deal for similar reasons. First, it can pick and choose which assets and liabilities to assume. This also decreases the amount of due diligence needed. Second, the buyer can write up the value of the assets purchased—known as a “step-up” in basis to fair market value over the historical carrying cost, which can create an additional depreciation write-off, becoming a tax benefit. Please note there are other, lesser-known legal advantages and disadvantages to
both transaction structures.

Question 24

What is a 10-K?

Answer 24

It’s a report similar to the annual report, except that it contains more detailed information about the company’s business, finances, and management. It also includes the bylaws of the company, other legal documents and information about any lawsuits in which the company is involved. All publicly traded companies are required to file a 10-K report each year to the SEC.

Question 25

What is Sarbanes-Oxley and what are the implications?

Answer 25

Sarbanes-Oxley was a bill passed by Congress in 2002 in response to a number of accounting scandals. To reduce the likelihood of accounting scandals, the law established new or enhanced standards for publicly held companies. Those in favor of this law believe it will restore investor confidence by increasing corporate accounting controls. Those opposed to this law believe it will hinder organizations that do not have a surplus of funds to spend on adhering to the new accounting policies.