Accounting Flashcards
What’s the difference between LIFO and FIFO? Can you walk me through an example of how they differ?
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 with FIFO you use the value of the oldest Inventory additions for COGS.
What are the three financial statements, and why do we need them?
The three main financial statements are the Income Statement, Balance Sheet, and Cash Flow Statement.
The Income Statement shows the company’s revenue, expenses, and taxes over a period and ends with Net Income, which represents the company’s after-tax profits.
The Balance Sheet shows the company’s Assets – its resources – as well as how it paid for those resources – its Liabilities and Equity – at a specific point in time. Assets must equal Liabilities plus Equity.
The Cash Flow Statement begins with Net Income, adjusts for non-cash items and changes in operating assets and liabilities (working capital), and then shows the company’s Cash Flow from Investing and Financing activities; the last lines show the net change in cash and the company’s ending cash balance.
How do the financial statements link together?
To link the statements, make Net Income from the Income Statement the top line of the Cash Flow Statement. Then, adjust this Net Income number for non-cash items such as Depreciation & Amortization. Next, reflect changes to operational Balance Sheet items such as Accounts Receivable, which may increase or reduce the company’s cash flow. This gets you to Cash Flow from Operations. Next, include investing and financing activities, which may increase or reduce cash flow, and sum up Cash Flow from Operations, Investing, and Financing to get the net change in cash at the bottom. Cash at the bottom of the CFS becomes Cash on the Balance Sheet, and Net Income, Stock Issuances, Stock Repurchases, Stock-Based Compensation, and Dividends link into Common Shareholders’ Equity. Next, link the separate line items on the CFS to their corresponding Balance Sheet line items; for example, CapEx and Depreciation link into Net PP&E. When you’re on the Assets side of the Balance Sheet, and you’re linking to the Cash Flow Statement, subtract CFS links; add them on the L&E side. Finally, check that Assets equals Liabilities plus Equity at the end.
What’s the most important financial statement?
The Cash Flow Statement is the most important single statement because it tells you how much cash a company is generating, and valuation is based on cash flow. The Income Statement includes non-cash revenue, expenses, and taxes, and excludes cash spending on major items such as Capital Expenditures, so it does not accurately represent a company’s cash flow.
What’s the difference between Assets, Liabilities, and Equity line items on the Balance Sheet?
An Asset is something that will result in a future benefit for the company, such as future cash flow, business growth, or tax savings. A Liability or Equity line item is something that will result in a future obligation for the company, such as a cash payment or the requirement to deliver a product.
How can you tell whether or not an item should appear on the Cash Flow Statement?
You list an item on the Cash Flow Statement if:
1) It has already appeared on the Income Statement and affected Net Income, but it’s non-cash, so you need to adjust to determine the company’s real cash flow; OR
2) It has NOT appeared on the Income Statement, and it DOES affect the company’s cash balance.
Why is Accounts Receivable (AR) an Asset, but Deferred Revenue (DR) a Liability?
AR is an Asset because it provides a future benefit to the company – the receipt of additional cash from customers in the future. DR is a Liability because it results in future obligations for the company. The company has already collected all the cash associated with the sale, so now it must deliver the product or service, and it must spend something to do that. AR and DR are the opposites of each other: AR has not yet been collected in cash but has been delivered, whereas DR has been collected in cash, but has not yet been delivered.
How are Prepaid Expenses, Accounts Payable and Accrued Expenses different, and why are Prepaid Expenses an Asset?
Prepaid Expenses have already been paid in cash but have not yet been incurred as expenses, so they have not appeared on the Income Statement. When they finally appear on the Income Statement, they’ll effectively be “non-cash expenses” that reduce the company’s taxes, which makes them an Asset. By contrast, Accounts Payable have not yet been paid in cash. When the company finally pays them, its Cash balance will decrease, which makes AP a Liability. Accounts Payable and Accrued Expenses work the same way, but Accounts Payable is used for specific items with invoices (e.g., legal bills), while Accrued Expenses is used for monthly, recurring items without invoices (e.g., utilities). Accrued Expenses almost always result in an Income Statement expense before being paid in cash, and Accounts Payable often do as well. However, in some cases, Accounts Payable may correspond to items that have not yet appeared on the Income Statement, such as purchases of Inventory made on credit.
Your CFO wants to start paying employees mostly in Stock-Based Compensation, under the logic that it will reduce the company’s taxes, but not “cost it” anything in cash. Is the CFO correct? And how does Stock-Based Compensation impact the statements?
The CFO is correct on a superficial level, but not in reality. First, the full amount of Stock-Based Compensation is not deductible for Cash-Tax purposes when it is initially granted in most countries, so even if Book Taxes decrease, Cash Taxes may not change at all. The eventual tax deduction will take place much further into the future when employees exercise their options and/or receive their shares. But the other problem with the CFO’s claim is that Stock-Based Compensation creates additional shares, diluting existing investors and, therefore, “costing” the company something. That makes it quite different from non-cash expenses that do not change the company’s capital structure, such as Depreciation and Amortization.
The CFO of your firm recently announced plans to purchase “financial investments” (stocks and bonds). Why would she want to do this, and how will this activity affect the statements?
For example, the company can’t hire more employees, buy more equipment or factories, or acquire other companies, and it also doesn’t want to issue Dividends to investors, repurchase stock, or repay Debt. The initial purchase of these investments will show up only on the Cash Flow Statement (in Cash Flow from Investing) and will reduce the company’s cash flow. Afterward, the Interest Income earned on these investments will appear on the Income Statement and boost the company’s Pre-Tax Income, Net Income, and its Cash balance.
Your firm recently acquired another company for $1,000 and created Goodwill of $400 and Other Intangible Assets of $200 on the Balance Sheet.
You need to create Goodwill and Other Intangible Assets after an acquisition takes place to ensure that the Balance Sheet balances. In an acquisition, you write down the seller’s Common Shareholders’ Equity and then combine its Assets and Liabilities with those of the acquirer. If you’ve paid exactly what the seller’s CSE is worth – e.g., you paid $1,000 in cash, and the seller has $1,000 in CSE, then there are no problems. The combined Cash balance decreases by $1,000, and so does the combined CSE. However, in real life, acquirers almost always pay premiums for target companies, which means that the Balance Sheet will go out of balance.
How do Goodwill and Other Intangible Assets change over time?
Goodwill remains constant unless it is “impaired,” i.e., the acquirer decides that the acquired company is worth less than it initially expected and writes down the Goodwill. That appears as an expense on the Income Statement and a non-cash adjustment on the Cash Flow Statement. Other Intangible Assets amortize over time (unless they are indefinite-lived), and that Amortization shows up on the Income Statement and as a non-cash adjustment on the Cash Flow Statement. The balance decreases until it has amortized completely.
How do Operating Leases and Finance Leases (Capital Leases) appear on the financial statements?
Assets and Liabilities associated with leases that last for more than 12 months now appear directly on companies’ Balance Sheets. Operating Lease Assets are sometimes called “Right-of-Use Assets,” and Operating Lease Liabilities initially match them on the other side. The rental expense for Finance Leases, which give companies an element of ownership or a “bargain purchase option” at the end, is split into Interest and Depreciation elements on the Income Statement. On the Cash Flow Statement, Depreciation is added back, and under Cash Flow from Financing, the company records a negative for the “Repayment of Lease Principal” (or similar name). On the Balance Sheet, both the Lease Assets and Lease Liabilities decrease each year until the lease ends.
What’s the difference between Deferred Tax Assets and Deferred Tax Liabilities, and how are Net Operating Losses (NOLs) related to both of them?
Both DTAs and DTLs relate to temporary differences between the book basis and the tax basis of assets and liabilities. Deferred Tax Assets represent potential future cash-tax savings for the company, while Deferred Tax Liabilities represent additional cash-tax payments in the future. DTLs often arise because of different Depreciation methods, such as when companies accelerate Depreciation for tax purposes, reducing their tax burden in the near term but increasing it in the future. They may also be created in acquisitions. DTAs may arise when the company loses money (i.e., negative Pre-Tax Income) in the current period and, therefore, accumulates a Net Operating Loss (NOL). They are also created when the company deducts an expense for Book-Tax purposes but cannot deduct it at the same time for Cash-Tax purposes (e.g., Stock-Based Compensation).
