Accounting (Advanced)

Question 1

Explain what a Deferred Tax Asset or Deferred Tax Liability is. How do they usually get created?

Answer 1

• A Deferred Tax Liability (DTL) means that you need to pay additional cash taxes in the future - in other words‚ you’ve underpaid on taxes and need to make up for it in the future.
• A Deferred Tax Asset (DTA) means that you can pay less in cash taxes in the future - you’ve paid too much before‚ and now you get to save on taxes in the future.
• Both DTLs and DTAs arise b/c of temporary differences between what a company can deduct for cash tax purposes and what they can deduct for book tax purposes. You see them most often in 3 scenarios:
1. When companies record Depreciation differently for book and tax purposes (i.e. more quickly for tax purposes to save on taxes)
2. When Assets get written up for book‚ but not tax purposes‚ in M&A deals.
3. When pension contributions get recognized differently for book vs. tax purposes.

Question 2

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 2

• This one’s subtle‚ but you frequently see both of these items on the statements b/c a company can owe AND save on future taxes - for different reasons.
• For example‚ they might have Net Operating Losses (NOLs) b/c they were unprofitable in early years‚ and those NOLs could be counted as DTAs.
• 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 3

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

Answer 3

• They are similar but not the exact same 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 b/c of events that do NOT occur in the normal course of business.

Question 4

Walk me through how you project revenue for a company.

Answer 4

• The simplest way to do it is to assume a percentage growth rate - for example‚ 15% in Year 1‚ 12% in Year 2‚ 10% in Year 3‚ and so on‚ usually decreasing significantly over time. To be more precise‚ you could create a “bottoms-up build” or a “tops-down build:”
• BOTTOMS-UP: Start w/ individual products/customers‚ estimate the average sale value or customer value‚ and then the growth rate in customers/transactions and customer transaction values to tie everything together.
• TOPS-DOWN: Start w/ “big-picture” metrics like overall market size‚ and then estimate the company’s market share and how that will change in coming years and multiply to get their revenue.
• Of these two methods‚ bottoms-up is more common and is taken more seriously b/c estimating the “big-picture” numbers is almost impossible.

Question 5

Walk me through how you project expenses for a company.

Answer 5

• The simplest method is to make each I/S expense a percentage of revenue and hold it fairly constant‚ maybe decreasing the percentages slightly (due to economies of scale)‚ over time.
• For a more complex method‚ you could start w/ each department of a company‚ the number of employees in each‚ the average salary‚ bonuses‚ and benefits‚ and then make assumptions for 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.
• COGS should be tied directly to Revenue and each “unit” sold should incur an expense.
• Other items such as rent‚ CapEx‚ and misc. expenses are linked to the company’s internal plans for building expansion plans (if they have them)‚ or to Revenue in a simpler model.

Question 6

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

Answer 6

Normally you assume that these are percentages of revenue or expenses‚ under the assumption that they’re all linked to the I/S:
• A/R (% of Revenue)‚ Prepaid Expense (% of Operating Expense)‚ Inventory (% of COGS)‚ Deferred Revenue (% of Revenue)‚ A/P (% of Operating Expenses)‚ Accrued Expenses (% of Operating Expenses)
• Then you either carry the same percentages across in future years or assume slight increases or decreases depending on the company.
• You can also project these metrics using “days‚” e.g. Accounts Receivable Days = Accounts Receivable / Revenue * 365‚ assume that the days required to collect A/R stays relatively the same each year‚ and calculate the A/R number from that.

Question 7

How should you project Depreciation and Capital Expenditures?

Answer 7

You could use several different approaches here:
• Simplest: Make each one a % of revenue.
• Alternative: Make Depreciation a % of revenue‚ but for CapEx average several years of CapEx‚ or make it an absolute dollar change (e.g. it increases by $100 each year) or percentage change (it increases by 2% each year).
• Complex: Create a PP&E schedule‚ where you estimate the CapEx increase each year based on management’s plans‚ and then Depreciate existing PP&E using each asset’s useful life and the straight-line method; also Depreciate new CapEx right after it’s added‚ using the same approach.

Question 8

There’s usually a “simple” and “complex” way of projecting a company’s financial statements. Is there a real advantage to using the complex method? In other words‚ does it give us better numbers?

Answer 8

• In short‚ no. The complex methods give you similar numbers most of the time - you’re not using them to get “better” numbers‚ but rather to get better support for those numbers.
• If you just say‚ “Revenue grows by 10% per year‚” there isn’t much evidence to back up that claim. But if you create a bottoms-up revenue model by segment‚ then you can say‚ “The 10% growth is driven by a 5% price increase in this segment‚ a 10% increase in units sold here‚ 15% growth in units sold in this geography” and so on.

Question 9

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

Answer 9

• Restructuring Charges‚ Goodwill Impairment‚ Asset Write-Downs‚ Bad Debt Expenses‚ One-Time Legal Expenses‚ Disaster Expenses‚ Changes in Accounting Policies
• Note that to qualify as an “add-back” or “non-recurring” charge for EBITDA / EBIT purposes‚ it needs to affect Operating Income on the Income Statement. So if one of these charges is “below the line‚” then you do not add it back for the EBITDA / EBIT calculation.
• Also note that you DO add back D&A and sometimes SBC when calculating EBITDA‚ but that these are not “non-recurring charges” b/c all companies have them every year - they’re just non-cash charges.

Question 10

What’s the difference between capital leases and operating leases? How do they affect the statements?

Answer 10

• 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 I/S and impact Operating Income‚ Pre-Tax Income‚ and NI.
• Capital Leases are used for longer-term items and give the lessee ownership rights; they Depreciate‚ incur Interest Expense‚ and are counted as Debt.
• A lease is a Capital Lease is 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 11

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

Answer 11

• The “quick and dirty” way: 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 Pre-Tax Income number (which should stay the same). Then you can deduct whatever you used up from the NOL balance (which should be a part of the DTA line item).
• A more complex way to 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 record the difference as an increase to the DTL on the B/S.
• 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 12

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 12

• 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 I/S.
• On the SCF‚ Excess Tax Benefits are subtracted out of CFO and added to CFF‚ 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 SCF‚ you add back the Tax Benefits in CFO. You do that b/c you want them to accrue to APIC on the B/S. You’re saying‚ “In addition to the additional value we created w/t his stock/option issuance‚ we’ve also gotten some value from the tax savings‚ so let’s reflect that value along with the SBC itself under APIC.”

Question 13

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 13

• 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 Q1 of Year 2 you would look at how much the company has grown revenue by in Q1 of previous years.
• It wouldn’t make much sense to use Quarter-over-Quarter growth (i.e. Q1 over Q4 in the previous year) b/c many companies are seasonal.
• The same applies for expenses as well: always make sure you take into account seasonality w/ quarterly projections.

Question 14

What’s the purpose of calendarizing financial figures?

Answer 14

• “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 Dec. 31 - if you calendarized it‚ you might look at the period from Jun. 30 in the previous year to Jun. 30 of this year rather than the traditional Jan. 1 - Dec. 31 period.
• You do this most frequently w/ public comps b/c companies often have “misaligned” fiscal years. If one company’s year ends Dec. 31‚ another’s ends Jun. 30‚ and another’s ends Sep. 30‚ you need to adjust and use the same time period for all of them - otherwise‚ you’re comparing apples to oranges b/c the financial figures are all from different time periods.

Question 15

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 15

• If Depreciation is higher on the tax schedule in the first few years‚ the DTL will increase b/c 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 16

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

Answer 16

• 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 SE when you combine its statement with yours‚ and you still allocate the purchase price.
• You also subtract NI Attributable to Noncontrolling Interests on the I/S - in other words‚ the other company’s Net Income * Percentage You Do Not Own. But then you add it back on the SCF in the CFO section. That is just an accounting rule and has no cash impact.
• On the B/S‚ the Noncontrolling Interest line item increases by that number (NI Attributable to Noncontrolling Interests) each year. RE decreases by that same number each year b/c it reduces NI‚ so the B/S remains in balance.

Question 17

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 17

• 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 B/S (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 NI * Percentage Ownership to your own NI on the I/S‚ and then subtract it on the SCF b/c 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‚ RE will also change based on the change in NI‚ so everything balances.

Question 18

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

Answer 18

• 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 the B/S‚ acting as if they have simply bought a stock or bond and ignoring the other company’s financials.

Question 19

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

Answer 19

• TRADING: These securities are very short-term and you count all Gains and Losses on the I/S‚ 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 and Losses on the I/S - they appear under Accumulated Other Comprehensive Income (AOCI). The B/S values of these Securities also change over time b/c 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 20

• 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 20

• I/S: You show a line item for “NI 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 NI that does not “belong” to you. At the bottom of the I/S‚ the “NI Attributable to Parent” line item is down by $3.
• SCF: NI is down by $3 as a result‚ but you add back this same charge b/c you do‚ in fact‚ receive this NI in cash when you own over 50% of the other company. So cash at the bottom of the SCF is unchanged.
• B/S: There are no changes on the Assets side. On the other side‚ the Noncontrolling Interests line item (included in SE) is up by $3 due to this NI‚ but RE is down by $3 b/c of the reduced NI at the bottom of the I/S‚ so this side doesn’t change and the B/S remains in balance.

Question 21

• You own 70% of a company that generates Net Income of $10. Everything above Net Income on your Income Statement has already been consolidated.
• Assume that this other company issues Dividends of $5‚ walk me through how that’s recorded on the statements.

Answer 21

• I/S: There are no changes b/c Dividends never show up on the I/S.
• SCF: There’s an additional Dividend of $5 under CFF on the SCF‚ so cash is down by $5.
• B/S: The Assets side is down by $5 as a result and SE (RE) is also down by $5.
• NOTE: Remember that the other company’s financial statements are consolidated w/ your own when you own over 50% - you only split out NI 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 NI.

Question 22

• You own 30% of another company that earns a Net Income of $20.
• Walk me through the 3 statements after you record the portion of Net Income that you’re entitled to.

Answer 22

Here‚ nothing has been consolidated b/c we own less than 50% of the other company. So nothing on the statements yet reflects this other company.
• I/S: We create an item “NI from Equity Interests” (or something similar) below our normal NI at the bottom‚ which results in our REAL NI (NI Attributable to Parent) increasing by $6 ($20 * 30%).
• SCF: NI is up by $6‚ but we subtract this $6 of additional NI b/c 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.
• B/S: The Investments in Equity Interests item on the Assets side increases by $6 to reflect this NI‚ so the Assets side is up by $6. On the other side‚ SE (RE) is up by $6 to reflect this increased NI‚ so both sides balance.

Question 23

• You own 30% of another company that earns a Net Income of $20. Assume that this 30% owned company issues Dividends of $10.
• Walk me through the 3 statements and explain what’s different prior to dividend issuance and afterwards.

Answer 23

• I/S: It’s the same: NI is up by $6 at the bottom.
• SCF: NI 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 CFO Section to reflect the Dividends that we receive from these Equity Interests. So cash at the bottom is up by $3.
• B/S: 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‚ NI is up by $6 so SE (RE) is up by $6 and both sides balance.
• NOTE: The Investments in Equity Interests line item is like a “mini-SE” for companies that you own less than 50% of - you add however much NI you can “claim‚” and then subtract out your portion of the Dividends.
• Remember that only the Dividends of the parent company itself issues show up in the CFF section - Dividends received from other companies (such as what you see in this example) do not.

Question 24

• What if you only own 10% of another company (instead of 30%) that earns a Net Income of $20.
• Would anything change based on these different assumptions?

Answer 24

• In theory‚ yes‚ b/c 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 NI 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 25

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

Answer 25

• I/S: Both forms of interest appear‚ so Pre-Tax Income falls by $20 and NI falls by $12 at a 40% tax rate.
• SCF: NI is down by $12‚ but you add back the $10 in PIK interest since it’s non-cash‚ so CFO is down by $2. Cash at the bottom is also down by $2 as a result.
• B/S: Cash is down by $2‚ so the Assets side is down by $2. On the other side‚ Debt increases by $10 b/c PIK Interest accrues to Debt‚ but SE (RE) falls by $12 due to the reduced NI‚ so this side is also down by $2 and both sides balance.
• NOTE: PIK Interest is just like any other non-cash charge: it reduces taxes but must affect something on the B/S - in this case‚ that’s the existing Debt number.

Question 26

• 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 26

• I/S: No changes.
• SCF: You add back the $100 in Tax Benefits from SBC in CFO and subtract out the $40 in Excess Tax Benefits‚ so CFO is up by $60. Then under CFF‚ you add back the $40 in Excess Tax Benefits‚ so Cash at the bottom is up by $100.
• B/S: Cash is up by $100‚ so the Assets side is up by $100. On the other side‚ Common Stock & APIC is up by $100 b/c Tax Benefits from SBC flow directly into there.
• The Rationale: Essentially we’re “reclassifying” the Tax Benefits OUT of CFO and saying that they should accrue to a company’s SE. 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 27

• 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 27

• I/S: On the Book I/S you list the Book Depreciation number‚ so Pre-Tax Income falls by $10 and NI falls by $6 with a 40% tax rate. On the Tax I/S‚ Depreciation was $15 so NI 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 $4. 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).
• SCF: On the Book Cash Flow Statement‚ NI 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.
• B/S: 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 DTL increases by $2 due to the Book/Cash Tax difference‚ but SE (RE) is down by $6 due to the lower NI‚ so both sides are down by $4 and balance.

Question 28

• 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 2.

Answer 28

This one’s easy b/c now Book and Tax Depreciation are the same.
• I/S: Pre-Tax Income is down by $10‚ so NI falls by $6.
• SCF: NI is down by $6 and you add back the $10 of Depreciation on the SCF‚ but there are no changes to Deferred Taxes b/c Book Depreciation = Tax Depreciation and therefore Book Taxes = Cash Taxes this year. Cash at the bottom increases by $4.
• B/S: 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 b/c SE (RE) is lower due the reduced NI.

Question 29

• 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 3.

Answer 29

• I/S: On the Book I/S‚ you use the Book Depreciation number so Pre-Tax Income falls by $10 and NI falls by $6 with a 40% tax rate. On the Tax I/S‚ Depreciation was $5 so NI 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).
• SCF: On the Book SCF‚ NI 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.
• B/S: 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 DTL decreases by $2 due to the Book/Cash Tax difference and SE (RE) is down by $6 due to the reduced NI‚ so both sides are down by $8 and balance.

Question 30

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 30

• I/S: You still reduce Pre-Tax Income by $100 due to the Impairment‚ so NI falls by $60 at a 40% tax rate - when it’s not tax-deductible‚ you make that adjustment via DTLs or DTAs. On the Tax I/S‚ Pre-Tax Income has not fallen at all and so NI stays the same‚ which means that Cash Taxes are $40 higher than Book Taxes.
• SCF: NI is down by $60‚ but we add back the $100 Impairment since it is non-cash. Then we also subtract $40 from Deferred Taxes b/c 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.
• B/S: 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 DTL is down by $40 and SE (RE) is down by $60 due to the reduced NI‚ 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 31

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

Answer 31

• 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 32

• 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 32

• I/S: The company can apply the entire NOL balance to offset its Pre-Tax Income‚ so Pre-Tax Income falls by $100 and NI falls by $60 at a 40% tax rate.
• SCF: NI 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 $40.
• B/S: Cash is up by $40 and the DTA is down by $100‚ so the Assets side is down by $60. On the other side‚ SE (RE) is down by $60 due to the reduced NI‚ so both sides balance.

Question 33

• You’re analyzing a company’s financial statements and you need to calendarize the revenue‚ EBITDA‚ and other items.
• The company earned revenue of $1000 and EBITDA of $200 from Jan. 1 to Dec. 31‚ 2050.
• From Jan. 1 to Mar. 31‚ 2050‚ it earned revenue of $200 and EBITDA of $50.
• From Jan. 1 to Mar. 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 Mar. 31‚ 2051?

Answer 33

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

So in this case:
• TTM Revenue = $300 + $1000 - $200 = $1100
• TTM EBITDA = $75 + $200 - $50 = $225

Question 34

• A company acquires another company for $1000 using 50% stock and 50% cash. The other company has 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 34

• 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 B/S 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 = $800.
• That $800 of Goodwill gets created on the Assets side‚ and so both sides are now up by $1300 and the B/S balances.

Question 35

• 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 35

• I/S: Since these are AFS Securities‚ you do NOT report unrealized Gains and Losses on the I/S. There are no changes.
• SCF: There are no changes b/c no cash accounts change.
• B/S: 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 SE‚ so the B/S balances.

Question 36

• You’re analyzing a company with $100 in Short-Term Investments on its Balance Sheet. These Investments are classified as Trading Securities.
• The market value for these securities increases to $110.
• Walk me through what happens on the 3 statements.

Answer 36

With Trading Securities‚ you DO show Unrealized Gains and Losses on the I/S.
• I/S: Both Operating Income and Pre-Tax Income increase by $10‚ and so NI increases by $6 at a 40% tax rate.
• SCF: NI is up by $6‚ but you subtract the Unrealized Gain of $10 b/c it’s non-cash‚ so Cash at the bottom is down by $4.
• B/S: 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‚ SE (RE) is up by $6 due to the increased NI.
• 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.