Accounting - Advanced

Question 1

How is GAAP accounting different from tax accounting?

Answer 1

1. GAAP is accrual-based but tax is cash-based.
2. GAAP uses straight-line depreciation or a few other methods whereas tax accounting is different (accelerated depreciation).
3. GAAP is more complex and more accurately tracks assets/liabilities whereas tax accounting is only concerned with revenue/expenses in the current period and what income tax you owe.

Question 2

What are deferred tax assets/liabilities and how do they arise?

Answer 2

They arise because of temporary differences between what a company can deduct for cash tax purposes vs. what they can deduct for book tax purposes.

Deferred Tax Liabilities arise when you have a tax expense on the Income Statement but haven’t actually paid that tax in cold, hard cash yet; Deferred Tax Assets arise when you pay taxes in cash but haven’t expensed them on the Income Statement yet.

The most common way they occur is with asset write-ups and write-downs in M&A deals – an asset write-up will produce a deferred tax liability while a write-down will produce a deferred tax asset.

Question 3

Walk me through how you create a revenue model for a company

Answer 3

There are 2 ways you could do this: a bottoms-up build and a tops-down build.

• Bottoms-Up: Start with individual products / customers, estimate the average sale value or customer value, and then the growth rate in sales and sale values to tie everything together.
• Tops-Down: Start with “big-picture” metrics like overall market size, then estimate the company’s market share and how that will change in coming years, and multiply to get to their revenue.

Of these two methods, bottoms-up is more common and is taken more seriously because estimating “big-picture” numbers is almost impossible.

Question 4

Walk me through how you create an expense model for a company

Answer 4

To do a true bottoms-up build, you start with each different department of a company, the # of employees in each, the average salary, bonuses, and benefits, and then make assumptions on 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.

Cost of Goods Sold should be tied directly to Revenue and each “unit” produced should incur an expense.

Other items such as rent, Capital Expenditures, and miscellaneous expenses are either linked to the company’s internal plans for building expansion plans (if they have them), or to Revenue for a more simple model.

Question 5

Let’s say we’re trying to create these models but don’t have enough information or the company doesn’t tell us enough in its filings – what do we do?

Answer 5

Use estimates. For the revenue if you don’t have enough information to look at separate product lines or divisions of the company, you can just assume a simple growth rate into future years.

For the expenses, if you don’t have employee-level information then you can just assume that major expenses like SG&A are a percent of revenue and carry that assumption forward.

Question 6

Walk me through the major items in Shareholders’ Equity.

Answer 6

Common items include:

• Common Stock – Simply the par value of however much stock the company has issued.
• Retained Earnings – How much of the company’s Net Income it has “saved up” over time.
• Additional Paid in Capital – This keeps track of how much stock-based compensation has been issued and how much new stock employees exercising options have created. It also includes how much over par value a company raises in an IPO or other equity offering.
• Treasury Stock – The dollar amount of shares that the company has bought back.
• Accumulated Other Comprehensive Income – This is a “catch-all” that includes other items that don’t fit anywhere else, like the effect of foreign currency exchange rates changing.

Question 7

Walk me through what flows into Retained Earnings

Answer 7

Retained Earnings = Old Retained Earnings Balance + Net Income – Dividends Issued

If you’re calculating Retained Earnings for the current year, take last year’s Retained Earnings number, add this year’s Net Income, and subtract however much the company paid out in dividends.

Question 8

Walk me through what flows into Additional Paid-In Capital (APIC)

Answer 8

APIC = Old APIC + Stock-Based Compensation + Stock Created by Option Exercises

If you’re calculating it, take the balance from last year, add this year’s stock-based compensation number, and then add in however much new stock was created by employees exercising options this year.

Question 9

What is the Statement of Shareholders’ Equity and why do we use it?

Answer 9

This statement shows everything we went through above – the major items that comprise Shareholders’ Equity, and how we arrive at each of them using the numbers elsewhere in the statement.

You don’t use it too much, but it can be helpful for analyzing companies with unusual stock-based compensation and stock option situations.

Question 10

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

Answer 10

• Restructuring Charges
• Goodwill Impairment
• Asset Write-Downs
• Bad Debt Expenses
• Legal Expenses
• Disaster Expenses
• Change in Accounting Procedures

Note that to be an “add-back” or “non-recurring” charge for EBITDA / EBIT purposes, it needs to affect Operating Income on the Income Statement. So if you have one of these charges “below the line” then you do not add it back for the EBITDA / EBIT calculation.

Also note that you do add back Depreciation, Amortization, and sometimes Stock-Based Compensation for EBITDA / EBIT, but that these are not “non-recurring charges” because all companies have them every year – these are just non-cash charges.

Question 11

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

Answer 11

Normally you make very simple assumptions here and assume these are percentages of revenue, operating expenses, or cost of goods sold. Examples:

• Accounts Receivable: % of revenue.
• Deferred Revenue: % of revenue.
• Accounts Payable: % of COGS.
• Accrued Expenses: % of operating expenses or SG&A.

Then you either carry the same percentages across in future years or assume slight changes depending on the company.

Question 12

How should you project Depreciation & Capital Expenditures?

Answer 12

The simple way: project each one as a % of revenue or previous PP&E balance.

The more complex way: create a PP&E schedule that splits out different assets by their useful lives, assumes straight-line depreciation over each asset’s useful life, and then assumes capital expenditures based on what the company has invested historically.

Question 13

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

Answer 13

The “quick and dirty” way to do this: 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 Pretax Income number (which should stay the same).

The way you should 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 book the difference as an increase to the Deferred Tax Liability on the Balance Sheet.

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 14

What’s the difference between capital leases and operating leases?

Answer 14

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 Income Statement.

Capital leases are used for longer-term items and give the lessee ownership rights; they depreciate and incur interest payments, and are counted as debt.

A lease is a capital lease if 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 15

Why would the Depreciation & Amortization number on the Income Statement be different from what’s on the Cash Flow Statement?

Answer 15

This happens if D&A is embedded in other Income Statement line items. When this happens, you need to use the Cash Flow Statement number to arrive at EBITDA because otherwise you’re undercounting D&A.

Question 16

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 16

This one’s subtle, but you frequently see both of these items on the statements because a company can owe and save on future taxes – for different reasons.

For example, they might have Net Operating Losses (NOLs) because they were unprofitable in early years, and those NOLs could be counted as Deferred Tax Assets.

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 17

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

Answer 17

They are similar, but not the same exact 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 because of events that do NOT occur in the normal course of business.

Question 18

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 18

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 Income Statement.

On the Cash Flow Statement, Excess Tax Benefits are subtracted out of Cash Flow from Operations and added to Cash Flow from Financing, 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 CFS, you add back the Tax Benefits in Cash Flow from Operations.

You do that because you want them to accrue to Additional Paid-In Capital (APIC) on the Balance Sheet. You’re saying, “In addition to the additional value we created with this stock/option issuance, we’ve also gotten some value from the tax savings… so let’s make reflect that value along with the SBC itself under APIC.”

Question 19

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 19

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 Quarter 1 of Year 2 you would look at how much the company has grown revenue by in Quarter 1 of previous years.

It wouldn’t make much sense to use Quarter-over-Quarter growth (i.e. Quarter 1 over Quarter 4 in the previous year) because many companies are seasonal.

The same applies for expenses as well: always make sure you take into account seasonality with quarterly projections.

Question 20

What’s the purpose of calendarizing financial figures?

Answer 20

“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 December 31 – if you calendarized it, you might look at the period from June 30 in the previous year to June 30 of this year rather than the traditional January 1 – December 31 period.

You do this most frequently with public comps (see the section on Valuation), because companies often have “misaligned” fiscal years. If one company’s year ends December 31, another’s ends June 30, and another’s ends September 30, you need to adjust and use the same period for all of them – otherwise you’re comparing apples to oranges because the financial figures are all from different time periods.

Question 21

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 21

If Depreciation is higher on the tax schedule in the first few years, the Deferred Tax Liability will increase because 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 22

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

Answer 22

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 Shareholders’ Equity when you combine its statements with yours, and you still allocate the purchase price (see the Merger Model section for more on that).

You also subtract Net Income Attributable to Noncontrolling Interests on the Income Statement – in other words, the other company’s Net Income * Percentage You Do Not Own. But then you add it back on the Cash Flow Statement in the CFO section. That is just an accounting rule and has no cash impact.

On the Balance Sheet, the Noncontrolling Interest line item increases by that number (Net Income Attributable to Noncontrolling Interests) each year. Retained Earnings decreases by that same number each year because it reduces Net Income, so the Balance Sheet remains in balance.

Question 23

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 23

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 Balance Sheet (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 Net Income * Percentage Ownership to your own Net Income on the Income Statement, and then subtract it on the Cash Flow Statement because 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, Retained Earnings will also change based on the change in Net Income, so everything balances.

Question 24

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

Answer 24

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 their Balance Sheet (see the next few questions), acting as if they have simply bought a stock or bond and ignoring the other company’s financials.

Question 25

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

Answer 25

• Trading: These Securities are very short-term and you count all Gains and Losses on the Income Statement, 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 or Losses on the Income Statement – they appear under Accumulated Other Comprehensive Income (AOCI). The Balance Sheet values of these Securities also change over time because 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 26

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 26

Income Statement: You show a line item for “Net Income 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 Net Income that does not “belong” to you.

At the bottom of the Income Statement, the “Net Income Attributable to Parent” line item is down by $3.

Cash Flow Statement: Net Income is down by $3 as a result, but you add back this same charge because you do, in fact, receive this Net Income in cash when you own over 50% of the other company.

So cash at the bottom of the CFS remains unchanged.

Balance Sheet: There are no changes on the Assets side. On the other side, the Noncontrolling Interests line item (included in Shareholders’ Equity) is up by $3 due to this Net Income, but Retained Earnings is down by $3 because of the reduced Net Income at the bottom of the Income Statement, so this side doesn’t change and the Balance Sheet remains in balance.

Question 27

Let’s continue with the same example, and assume that this other company issues Dividends of $5. Walk me through how that’s recorded on the statements.

Answer 27

Income Statement: There are no changes because Dividends never show up on the Income Statement.

Cash Flow Statement: There’s an additional Dividend of $5 under Cash Flow from Financing on the CFS, so cash is down by $5.

Balance Sheet: The Assets side is down by $5 as a result and Shareholders’ Equity (Retained Earnings) is also down by $5.

Remember that the other company’s financial statements are consolidated with your own when you own over 50% – you only split out Net Income 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 Net Income.

Question 28

Now let’s take the opposite scenario and say that you own 30% of another company. The other company earns Net Income of $20. Walk me through the 3 statements after you record the portion of Net Income that’s you’re entitled to.

Answer 28

Here, nothing has been consolidated because we own less than 50% of the other company. So nothing on the statements yet reflects this other company.

Income Statement: We create an item “Net Income from Equity Interests” (or something similar) below our normal Net Income at the bottom, which results in our real Net Income (Net Income Attributable to Parent) increasing by $6 ($20 * 30%).

Cash Flow Statement: Net Income is up by $6, but we subtract this $6 of additional Net Income because 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.

Balance Sheet: The Investments in Equity Interests item on the Assets side increases by $6 to reflect this Net Income, so the Assets side is up by $6. On the other side, Shareholders’ Equity (Retained Earnings) is up by $6 to reflect the increased Net Income, so both sides balance.

Question 29

Now let’s assume that this 30% owned company issues Dividends of $10. Taking into account the changes from the last question, walk me through the 3 statements again and explain what’s different now.

Answer 29

Income Statement: It’s the same: Net Income is up by $6 at the bottom.
Cash Flow Statement: Net Income 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 Cash Flow from Operations section to reflect the Dividends that we receive from these Equity Interests.

So cash at the bottom is up by $3.

Balance Sheet: 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, Net Income is up by $6 so Shareholders’ Equity (Retained Earnings) is up by $6 and both sides balance.

The Investments in Equity Interests line item is like a “mini-Shareholder’s Equity” for companies that you own less than 50% of – you add however much Net Income you can “claim,” and then subtract your portion of the Dividends.

Remember that only the Dividends the parent company itself issues show up in the Cash Flow from Financing section – Dividends received from other companies (such as what you see in this example) do not.

Question 30

What if you now only own 10% of this company? Would anything change?

Answer 30

In theory, yes, because 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 Net Income 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 31

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

Answer 31

Income Statement: Both forms of interest appear, so Pre-Tax Income falls by $20 and Net Income falls by $12 at a 40% tax rate.

Cash Flow Statement: Net Income is down by $12 but you add back the $10 in PIK interest since it’s non-cash, so Cash Flow from Operations is down by $2. Cash at the bottom is also down by $2 as a result.

Balance Sheet: Cash is down by $2 so the Assets side is down by $2. On the other side, Debt increases by $10 because PIK interest accrues to Debt, but Shareholders’ Equity (Retained Earnings) falls by $12 due to the reduced Net Income, so this side is also down by $2 and both sides balance.

PIK Interest is just like any other non-cash charge: it reduces taxes but must affect something on the Balance Sheet – in this case, that’s the existing Debt number.

Question 32

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 32

Income Statement: No changes.

Cash Flow Statement: You add back the $100 in Tax Benefits from SBC in Cash Flow from Operations, and subtract out the $40 in Excess Tax Benefits, so CFO is up by $60.

Then, under Cash Flow from Financing, you add back the $40 in Excess Tax Benefits, so Cash at the bottom is up by $100.

Balance Sheet: Cash is up by $100, so the Assets side is up by $100. On the other side, Common Stock & APIC is up by $100 because Tax Benefits from SBC flow directly into there.

The rationale: Essentially we’re “re-classifying” the Tax Benefits OUT of Cash Flow from Operations and saying that they should accrue to the company’s Shareholders’ Equity. 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 33

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 33

Income Statement: On the Book Income Statement you list the Book Depreciation number, so Pre-Tax Income falls by $10 and Net Income falls by $6 with a 40% tax rate.

On the Tax Income Statement, Depreciation was $15 so Net Income 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 $40… 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).

Cash Flow Statement: On the Book Cash Flow Statement, Net Income 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.

Balance Sheet: 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 Deferred Tax Liability increases by $2 due to the Book / Cash Tax difference, but Shareholders’ Equity (Retained Earnings) is down by $6 due to the lower Net Income, so both sides are down by $4 and balance.

Question 34

Now let’s move to Year 2. What happens?

Answer 34

This one’s easy, because now Book and Tax Depreciation are the same.

Income Statement: Pre-Tax Income is down by $10 so Net Income falls by $6.

Cash Flow Statement: Net Income is down by $6 and you add back the $10 of Depreciation on the CFS, but there are no changes to Deferred Taxes because Book Depreciation = Tax Depreciation and therefore Book Taxes = Cash Taxes this year. Cash at the bottom increases by $4.

Balance Sheet: 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 because Shareholders’ Equity (Retained Earnings) is lower due to the reduced Net Income.

Question 35

And finally, let’s move to Year 3 – walk me through what happens on the statements now.

Answer 35

Income Statement: On the Book Income Statement, you use the Book Depreciation number so Pre-Tax Income falls by $10 and Net Income falls by $6 with a 40% tax rate.

On the Tax Income Statement, Depreciation was $5 so Net Income 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).

Cash Flow Statement: On the Book Cash Flow Statement, Net Income 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.

Balance Sheet: 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 Deferred Tax Liability decreases by $2 due to the Book/Cash Tax difference and Shareholders’ Equity (Retained Earnings) is down by $6 due to the reduced Net Income, so both sides are down by $8 and balance.

Question 36

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 36

Income Statement: You still reduce Pre-Tax Income by $100 due to the Impairment, so Net Income falls by $60 at a 40% tax rate – when it’s not tax- deductible, you make that adjustment via Deferred Tax Liabilities or Deferred Tax Assets.

On the Tax Income Statement, Pre-Tax Income has not fallen at all and so Net Income stays the same… which means that Cash Taxes are $40 higher than Book Taxes.

Cash Flow Statement: Net Income is down by $60, but we add back the $100 Impairment since it is non-cash.

Then, we also subtract $40 from Deferred Taxes because 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.

Balance Sheet: 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 Deferred Tax Liability is down by $40 and Shareholders’ Equity (Retained Earnings) is down by $60 due to the reduced Net Income, 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 37

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

Answer 37

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 38

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 38

Income Statement: The company can apply the entire NOL balance to offset its Pre-Tax Income, so Pre-Tax Income falls by $100 and Net Income falls by $60 at a 40% tax rate.

Cash Flow Statement: Net Income 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 by $40.

Balance Sheet: Cash is up by $40 and the Deferred Tax Asset is down by $100, so the Assets side is down by $60. On the other side, Shareholders’ Equity (Retained Earnings) is down by $60 due to the reduced Net Income, so both sides balance.

Question 39

You’re analyzing a company’s financial statements and you need to calendarize the revenue, EBITDA, and other items.

The company has earned revenue of $1000 and EBITDA of $200 from January 1 to December 31, 2050. From January 1 to March 31, 2050, it earned revenue of $200 and EBITDA of $50. From January 1 to March 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 March 31, 2051?

Answer 39

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

So in this case, TTM Revenue = $300 + $1000 – $200 = $1100 and TTM EBITDA = $75 + $200 – $50 = $225.

Question 40

A company acquires another company for $1000 using 50% stock and 50% cash. Here’s what the other company looks like:

• 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 40

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 Balance Sheet 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, or $800.
That $800 of Goodwill gets created on the Assets side, and so both sides are now up by $1300 and the Balance Sheet balances.

Question 41

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 41

Income Statement: Since these are AFS securities, you do not reported Unrealized Gains and Losses on the Income Statement. There are no changes.

Cash Flow Statement: There are no changes because no cash accounts change.

Balance Sheet: 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 Shareholders’ Equity, so the Balance Sheet balances.

Question 42

Now let’s say that these were classified as Trading Securities instead – walk me through the 3 statements after their value increases by $10.

Answer 42

With Trading Securities, you do show Unrealized Gains and Losses on the Income Statement.

Income Statement: Both Operating Income and Pre-Tax Income increase by $10, and so Net Income increases by $6 at a 40% tax rate.

Cash Flow Statement: Net Income is up by $6, but you subtract the Unrealized Gain of $10 because it’s non-cash, so Cash at the bottom is down by $4.

Balance Sheet: 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, Shareholders’ Equity (Retained Earnings) is up by $6 due to the increased Net Income.

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.