Accounting - Basic Flashcards
Walk me through the three financial statements
The 3 major financial statements are the income statement, balance sheet, and cash flow statement.
The income statement gives the companies revenue and expenses, and goes down to net income, the final line on the statement.
The balance sheet shows company’s assets (resources) such as cash, inventory, and PP&E, as well as its liabilities, such as debt and accounts payable, and shareholders equity. Assets must equal liabilities plus shareholders equity.
The cash flow statement begins with net income, adjusts for non-cash expenses and working capital changes, and then lists cash flow from investing activities and financing activities. At the end, you see the company’s net change in cash.
If Depreciation is a non-cash expense, why does it affect the cash balance?
Because it is tax-deductible. Since taxes are a cash expense, depreciation affects cash by reducing taxes.
Where does depreciation usually show up on the income statement?
It could be in a separate line item, or it could be embedded in COGS or operating expenses. Every company does it differently.
*End result for accounting questions is the same: depreciation always reduces pre-tax income
What happens when accrued compensation goes up by $10?
Assume accrued compensation now being recognized as an expense (as opposed to just changing non-accrued to accrued compensation)
Operating expenses on income statement go up by $10, pre-tax income galls by $10, and net income falls by $6 (assuming 40% tax rate).
On CFS, net income down by $6, accrued compensation will increase cash flow by $10, so overall cash flow from operations is up by $4 and net change in cash at the bottom is up by $4.
On BS, cash up by $4 as a result, so assets are up by $4. On liabilities/equity side, accrued compensation is a liability so liabilities are up by 10 and retained earnings are down by $6 due to the net income, so both sides balance.
What happens when inventory goes up by $10, assuming you pay for it with cash?
No changes to IS.
On cash flow statement, inventory is an asset so that decreases your cash flow from operations, which goes down by $10, as does net change in cash at the bottom.
On balance sheet under assets, inventory up by $10 but cash is down by $10, so changes cancel out and assets still equals liabilities & shareholders’ equity.
Major line items on income statement
- Revenue
- COGS
- SG&A
- Operating Income
- Pretax Income
- Net Income
Major line items on balance sheet
Cash, Accounts Receivable, Inventory, PP&E, Accounts Payable, Accrued Expenses, Debt, Shareholders Equity
Major line items on cash flow statement
Net Income; Depreciation & Amortization; Stock-Based Compensation; Changes in Operating Assets & Liabilities; Cash Flow From Operations; Capital Expenditures; Cash Flow From Investing; Sale/Purchase of Securities; Dividends Issued; Cash Flow From Financing.
How do the three statements link together?
To tie the statements together, Net Income from the Income Statement flows into Shareholders’ Equity on the Balance Sheet, and into the top line of the Cash Flow Statement.
Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement, and investing and financing activities affect Balance Sheet items such as PP&E, Debt and Shareholders’ Equity. The Cash and Shareholders’ Equity items on the Balance Sheet act as “plugs,” with Cash flowing in from the final line on the Cash Flow Statement.
If I were stranded on a desert island and only had one financial statement and I wanted to review the overall health of a company, which statement would I use and why?
You would use cash flow statement because it gives true picture of how much cash the company is actually generating, independent of all the non-cash expenses you might have. And cash flow is #1 thing you care about in analyzing financial health of a business.
If you could look at 2 statements, which two would you use and why?
Then you would pick the income statement and balance sheet because you can create the CFS from both of them (assuming you have “before” and “after” versions of balance sheet corresponding to period income statement tracks
Walk me through how depreciation going up by $10 would affect the statements?
Income statement: operating income would decline by $10, and assuming a 40% tax rate, net income would go down by $6 because of reduced tax expense
CFS: net income at top goes down by $6, but $10 depreciation is a non-cash expense that gets added back, so overall cash flow from operations goes up by $4. There are no changes elsewhere, so the overall net change in cash goes up by $4.
BS: PP&E goes down by $10 on assets side because of depreciation, and cash is up by $4 from changes on CFS
Overall: assets is down by $6. Since net income fell by $6 as well, shareholders’ equity is down by $6 and both sides of the balance sheet balance.
*Remember that an asset going up decreases your cash flow, whereas a liability going up increases your cash flow
Why is the income statement not affected by changes in inventory?
This is a common interview mistake, incorrectly stating that working capital changes show up on income statement.
In the case of inventory, the expense is only recorded when the goods associated with it are sold. So if it’s just sitting in a warehouse, it does not count as a cost of good sold or operating expense until the company manufactures it into a product and sells it.
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?
No changes yet to IS at start of year 1.
On CFS, additional investment in factories would show up under cash flow from investing as a net reduction in cash flow of $100 so far. But the additional $100 worth of debt raised would show up as an addition to cash flow, canceling out investment activity. So cash number stays the same.
On BS there is now $100 worth of factories in PP&E, so assets is up by $100. On the other side, debt is up by $100 as well so both sides balance
Now going out 1 year to start of year 2. Assume debt is high yield so no principal is paid off, and assume an interest rate of 10%. Also assume factories depreciate at a rate of 10% per year. What happens?
Apple must pay interest expense and must record the depreciation.
Operating income would decrease by $10 due to the 10% depreciation charge each year, and the $10 in interest expense would decrease pre tax income by $20 altogether.
Assuming 40% tax rate, net income would fall by $12 (20-20*.4)
On CFS, net income at top is down by $12. Depreciation is a non-cash expense, so you add it back and the end result is that cash flow from operations is down by $2.
That’s only change on CFS, so overall cash is down by $2.
On BS, under assets, cash down $2, PP&E down $10 from depreciation, so assets are down by $12 total.
On other side, since net income was down by $12, shareholders’ equity is also down by $12 and both sides balance.
*Remember, debt number under liabilities does not change since we’ve assumed none of the debt is actually paid back
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 paid back now. Walk me through the 3 statements.
After 2 years, the value of the factories is now $80 if we go with the 10% depreciation per year assumption. It is this $80 that we will write down in the 3 statements.
On IS, $80 write-down shows up in pre-tax income line. With 40% tax rate net income declines by $48.
On the CFS, net income down $48 but write-down is a non-cash expense, so we add it back, and cash flow from operations increases by $32.
No changes under cash flow from investing, but under cash flow from financing there is a $100 charge for the loan payback, so cash flow from investing falls by $100.
Thus, overall net change in cash falls by $68.
BS: cash down by $68 and PP&E down by $80, so assets decreased by $148.
On other side, debt down $100 since it was paid off, and since net income dropped by $48, shareholders’ equity down by $48 as well. Liabilities and shareholders’ equity down by $148 so both sides balance.
Now looking at a different scenario, assume Apple is ordering $10 of additional Ipod inventory using cash on hand. They order inventory but have not manufactured or sold anything yet. What happens to 3 statements?
IS: no changes
CFS: inventory up by $10, so cash flow from operations decreases by $10. No further changes so cash down by $10 overall.
BS: inventory up by $10 and cash down by $10 so assets number stays same and BS remains in balance.
Now say they sell Ipods for revenue of $20 at a cost of $10. Walk me through the 3 statements under this scenario.
IS: revenue up by $20 and COGS up by $10, so gross profit is up by $10 and operating income is up by $10 as well. Assuming 40% tax rate, net income is up by $6.
CFS: net income at top up by $6 and inventory has decreased by $10, but that’s a net addition to cash flow. So cash flow from operations is up by $16. Thus, net change in cash is up by $16.
BS: cash up by $16 and inventory down by $10, so assets are up by $6.
On the other side, net income was up by $6 so shareholders’ equity is up by $6 and both sides balance.
Can you ever end up with negative shareholders’ equity? What does it mean?
Common in 2 scenarios.
Leveraged buyouts with dividend recapitalizations - it means the owner of the company has taken out a large portion of its equity, which can sometimes turn the number negative.
It can also happen if company losing money consistently and has a declining retained earnings balance, which is a portion of shareholders’ equity.
Doesn’t mean anything in particular but can be a cause for concern.
*Shareholders’ equity doesn’t turn negative immediately after an LBO, only following dividend recap or continued net losses
Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there’s a write down of $100.
IS: $100 write-down shows up in pre-tax income line. With 40% tax rate, net income falls by $60.
CFS: net income down $60 but write-down is a non-cash expense, so we add it back, and cash from operations increases by $40.
Overall, net change in cash rises by $40.
BS: cash up by $40, but an asset is down by $100 (whatever was written-down), so overall assets are down by $60.
On other side, since Net income was down by $60, Shareholders’ Equity is down by $60, and both sides balance.
Walk me through a $100 bailout of a company and how it affects the three statements
First need to confirm what type of bailout this is. Debt, equity, or combination? Most common scenario is equity investment from the government, so here’s what happens:
IS: no changes
CFS: cash flow from financing goes up by $100 from gov investment, so net change in cash up $100.
BS: cash up by $100 so assets are up by $100.
On other side, SE up by $100 to make it balance.
Walk me through a $100 write-down of debt (as in OWED debt, a liability) on a company’s balance sheet and how it affects the 3 statements.
When a liability is written down you record it as a gain on the income statement (whereas asset write-down is a loss), so pre-tax income goes up by $100 due to the write-down. Assuming 40% TR, net income is up by $60.
CFS: net income up by $60, but need to subtract debt write-down, so cash from operations is down by $40, and net change in cash down by $40.
BS: cash down by $40 so assets down by $40. On other side, debt down by $100 but shareholders’ equity up $60 because net income was up by $60, so liabilities and shareholders’ equity down by $40 overall and it balances.
When would a company collect cash from a customer and not record it as revenue?
Three main examples:
Web-based subscription software
Cell phone carriers that sell annual contracts
Magazine publishers that sell subscriptions
Companies that agree to services in the future often collect cash upfront to ensure stable revenue. But per rules of GAAP, you only record revenue when you actually perform the services, so the company would not record everything as revenue right away.
If cash collected is not recorded as revenue, what happens to it?
Usually it goes into deferred revenue balance on balance sheet under liabilities.
Over time as services are performed, deferred revenue balance turns into real revenue on income statement.
