Accounting and the 3 Financial Statements Flashcards
What are the 3 financial statements, and why do we need them?
I/S, B/S and CF/S.
- I/S: Shows the company’s revenue, expenses and taxes over a period and ends with net income, representing after-tax profits.
- B/S: shows assets (resources) and how it paid for them (liabilities + equity) at a specific point in time. A = L + E.
- CF/S: Begins with Net Income, adjusts for non-cash items and changes in working capital, then shows company’s CFI & CFF; the final lines show net change in cash and ending cash balance.
Need these b/c there’s a difference between NI & cash flow.
How do the 3 statements link together?
- NI from I/S = top line of CF/S.
2, Adjust for non-cash items (D&A ) and operating working capital (A/R, A/P, inventory, accrued expenses) to get CFO. - Account for investing and financing activities, sum with CFO to get net change in cash.
- Cash at end of CF/S links to cash on B/S. Add NI to R/E.
- Link CF/S adjustments to appropriate A&L on B/S (i.e., increase in A/P).
What’s the most important F/S?
CF/S - tells you how much cash company generates. I/S includes non-cash items like D&A and excludes cash spending such as capex.
What if you could use only 2 statements to assess a company’s prospects - which ones would you use, and why?
I/S + B/S. Combined, you can recreate the CF/S. Reverse would be much harder.
How might the F/S of a company in the U.K. or Germany differ from a U.S.-based one?
I/S and B/S will be similar, but companies using IFRS often begin the CF/S with something other than NI. May also have naming differences (i.e., P&L).
What should you do if a company’s CF/S starts with something other than NI, suhc as EBIT or cash received?
-Modeling: convert into one beginning with NI.
See if there is a reconciliation.
How do you know when a revenue or expense line item should appear on the I/S?
Two conditions to appear on I/S:
- Corresponds only to period shown on I/S;
- Must affect company’s taxes.
How can you tell whether an item should be classified as an Asset, Liability or Equity on the B/S
Assets generate future cash flow or can be sold for cash.
Liabilities cost the company cash in the future and can’t be sold b/c represents PMTs the co. owes.
Equity represents funding sources for the company - they don’t result in future cash flows.
How can you tell whether or not an item should appear on the CF/S?
List if:
- Already appeared on I/S and affected NI, but it’s non-cash (D&A); or
- Didn’t appear on I/S and affects cash (capex).
A company uses cash accounting rather than accrual accounting. If a customer buys a TV on account and receives it immediately, how would the company record that transaction differently than under accrual?
- Cash: revenue wouldn’t show up until cash were received. Then, add to revenue, etc. on I/S and B/S cash.
- Accrual: record revenue and A/R. Once cash deposited, decrease A/R and increase cash.
A company begins offering 12-month installment plans to customers so that they can pay for $500 or $1,000 courses over a year instead of all upfront.
This year, company’s cash flow will decrease b/c some customers won’t be paying upfront: $1K now becomes $83/month (A/R instead of cash).
Long-term, depends on resulting sales growth. If high, then increases to EBIT and NI may offset and make the company better off.
How would depreciation going up by $10 affect the 3 F/S?
I/S - assuming 40% tax rate, EBIT would fall $10 and NI $6.
CF/S - NI down $6, but $10 gets added back, so CFO is up $4. Net change in cash up $4.
B/S - net PP&A is down $10 and cash is up $4.
In sum, assets and equity are both down $6.
If depreciation is a non-cash expense, why does it affect the cash balance?
It is tax-deductible, so depreciation reduces tax expense, a cash item.
Where does depreciation usually show up on the I/S?
Depends: could be a separate line item or embedded in COGS or SG&A. Doesn’t change the result.
What happens if accrued compensation goes up by $10?
Assuming it’s being recognized as an expense:
I/S - salaries expense increases $10, so EBIT falls $10. At 40% tax rate, NI falls $6.
CF/S - NI is down $6, but change to accrued comp. increases by $10, so CFO is up $4. No other changes, so change in cash is $4.
B/S - Cash is up $4, liabilities are up $10 and equity is down $6.
What happens when inventory goes up by $10, assuming you pay for it with cash?
I/S - no changes.
CF/S - change in inventory is $10, so CFO is down $10. Change in cash = ($10).
B/S - Assets net out zero.
Why is the I/S unaffected by changes in inventory?
COGS expense is only recorded upon sale.
Let’s say Apple is buying $100 worth of new iPod factories with debt. How are all 3 statements affected at the start of Year 1, before anything else happens?
I/S - no changes.
CF/S - capex = ($100). CF from debt proceeds = 100. Net change in cash = $0.
B/S - increase PP&E by $100, debt (liability) by $100.
(Apple new factory example) At the start of Year 2, assuming the debt is high-yield so no debt is repaid, the coupon is 10% and the factories depreciate at 10%/yr, what happens?
I/S - Interest expense = $10, depreciation = $10. EBIT = ($20), NI = ($12).
CF/S - NI is down $12, add back $10 of D&A so CFO = ($2).
B/S - Cash is down $2, PP&E is down $10 so assets down $12. Balanced by equity being down $12.
(Apple new factory example) At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be repaid. What happens?
I/S - Factories have depreciated down to $80, so take an $80 expense (hits EBIT). At 40%, NI falls $48.
CF/S - NI = ($48) but write-off is non-cash, so +$80 = $32. CFF = ($100) from loan repayment. Change in cash = ($68).
B/S - Assets are down $68 from cash and $80 from write-off, totaling ($148). Liabilities are down $100 from debt and $48 from equity, so balanced.
