Accounting - Basic

Question 1

Walk me through the 3 financial statements

Answer 1

Income statement (revenues and expenses, goes down to net income)

Balance sheet (assets, liabilities and SE)

Cash Flow statement (begins with net income, adjusts for non-cash expenses and shows cash flows from operating, financing and investing activities, ending in net cash)

Question 2

Give examples of major line items on the financial statements

Answer 2

IS: Revenue, COGS, Depreciation, Interest expense

BS: Cash, AR, AP, Payroll liabilities, Retained earnings

CF: Net Income, Depreciation & Amortization, Stock-Based Comp, Capex, Change in AR, Change in AP

Question 3

How do the 3 statements link together?

Answer 3

Net income from the IS flows into SE on the BS, and into the top line of the CF statement.

Changes to BS items appear as NWC changes on the CF statement, and investing/financing activities impact PP&E, Debt, and SE.

Net changes in cash flows into the BS.

Question 4

What is the most important statement when assessing the health of a company?

Answer 4

CF, as it shows how much cash the business is generating and adjusts for accounting gains/losses. An investor in a business would care most about cash flow, as this forms the basis for valuations.

Question 5

If you could only look at 2 statements to assess a company’s prospects, what would you choose?

Answer 5

BS and IS, as you can use these to create the CF statement. You would therefore have the full picture.

Question 6

How would depreciation going up by $10 impact the 3 statements?

Answer 6

IS: operating expenses goes up by $10, pre-tax income goes down by $10. (assume 40% tax) Net income goes down by $6.

CF: Net income flows into CF, down by $6. Non-cash adjustment of +$10. Net changes in cash +$4.

BS: Cash flows into BS +$4 (tax savings). Accum. depr. +$10, therefore Assets -$6 net. Net income from IS flows into retained earnings on SE -$6.

Question 7

If depreciation is non-cash, why does +$10 depreciation result in +$4 cash?

Answer 7

Increased depreciation reduces pre-tax income, which means less cash is paid out in taxes.

Question 8

Where does depreciation usually show up on the IS?

Answer 8

Usually in Opex or COGS.

Question 9

What happens when accrued comp goes up by $10?

Answer 9

(Assume +accrued comp also means +salaries expense)

IS: Salaries and payroll expense +$10, reducing pre-tax income by $10. After-tax income falls by $6 (40% tax).

CF: Net income flows to CF -$6. Change in accrued comp goes up $10, cash flow from operations +$10. Net change in cash +$4.

BS: Cash flows into BS +$4. Accrued Comp +$10, liabilities +$10. Net income -$6 flows into SE.

Question 10

What happens when inventory goes up by $10, assuming you pay in cash?

Answer 10

IS: No change to IS as inventory has not been sold (no COGS change).

CF: Change in inventory +$10, cash flow from operations -$10. Net change in cash -$10.

BS: Cash flows into BS -$10. Inventory increased +$10. No net change to assets.

Question 11

Why is the income statement not impacted by changes to Inventory?

Answer 11

Inventory is held as a current asset until it is sold, at which point it is recognized as COGS.

Question 12

What happens at the start of yr 1 when you increase PP&E by $100 if you fund the capex with debt?

Answer 12

IS: No change, as no depreciation recorded and assets / debt have been capitalized.

CF: Change in PP&E +$100, cash flow from investing activities -$100. Change in debt is +$100. Cash flow from financing activities is +$100. Net change in cash is zero.

BS: PP&E increased by $100, assets +$100. Debt +$100, liabilities +$100. BS balances.

Question 13

What happens at the start of yr 2 when you increase PP&E by $100 if you fund the capex with debt? Assume no principal paid on the debt and 10% interest and depreciation rates.

Answer 13

IS: Depreciation expense +$10, interest expense +$10. Operating expenses +$20, pre-tax income -$20. Net income -$12 (40% tax).

CF: Net income flows into CF -$12. Depreciation add back $10. Cash flow from operations -$2. Net changes in cash -$2.

BS: Cash flows into BS -$2. Accumulated depreciation +$10, PP&E -$10. Assets -$12. Net income flows into SE -$12. L + SE -$12. BS balances.

Question 14

At the start of yr 3, the PP&E is written down to 0 and the loan is repaid. Walk me through the 3 statements.

Answer 14

IS: $80 write down (loss on write-down), other income -$80. Pre-tax income -$80. Net income -$48.

CF: Net income flows to CF -$48. Loss on write-down add back +$80, cash flow from operations +$32. Change in debt -$100, cash flow from financing activities -$100. Net change in cash -$68.

BS: Cash flows into BS -$68. PP&E written down -$80. Net change in assets -$148. Decreased debt -$100. Net income flows into BS -$48. L + SE -$148. BS balances.

Question 15

What happens when you order $10 of inventory and pay in cash, but have not manufactured or sold anything yet?

Answer 15

IS: No change.

CF: Change in inventory +$10. Cash flows from operations -$10. Net change in cash -$10.

BS: Cash flows into BS -$10. Inventory +$10. No net change in assets.

Question 16

What happens when the inventory is sold for $20 at a cost of $10.

Answer 16

IS: Revenue +$20, COGS +$10, gross margin +$10. Pre-tax income +$10. Net income increases by $6 (40% tax).

CF: Net income flows into CF +$6. Change in inventory -$10. Cash flow from operations +$16. Net change in cash +$16.

BS: Cash flows into BS +$16. Inventory -$10. Assets net +$6. Net income flows into SE through RE +$6. BS balances.

Question 17

Can you ever have negative SE?

Answer 17

Yes, if retained earnings has been declining consistently through net losses, SE can turn negative.

Can also happen in dividend recap (capital stock turned into debt after LBO)

Question 18

What is Working Capital? How is it used?

Answer 18

WC = Current Assets - Current Liabilities

Assets and liabilities needed by a company to sustain its normal operations. Positive WC means the company can pay its upcoming liabilities with its current assets.

Question 19

What does negative working capital mean? Is it a bad sign?

Answer 19

Means current assets can not cover current liabilities.

Bad sign if company doesn’t have up front payments from customers and has high debt.

Not a bad sign if company has retail/subscription revenue, where cash is received up front and large deferred revenue balances are recorded. Cash is usually used to pay AP, rather than kept on hand, leading to negative WC.

Question 20

What happens when there is a write down of $100 on the 3 statements?

Answer 20

IS: Loss on write-down -$100, pre-tax income decreases by $100. Net income decreases by $60 (40% tax).

CF: Net income flows to CF -$60. Loss on write-down non-cash adjustment +$100. Cash from operations +$40. Net change in cash +$40.

BS: Cash flows into BS +$40. Unknown asset -$100. Assets -$60. Net income flows into SE -$60. L + SE -$60. BS balances.

Question 21

What happens when there is an equity bailout of $100?

Answer 21

IS: No change

CF: Cash from financing +$100. Net changes in cash +$100.

BS: Cash +$100. Assets +$100. APIC / other equity account +$100. BS balances.

Question 22

What happens when owed debt is written down $100?

Answer 22

IS: Gain on write-down $100, pre-tax income +$100. Net income +$60 (40% tax).

CF: Net income flows to CF +$60. Cash flows from operations +$60. Change in debt -$100, cash flows from financing -$100. Net change in cash $-40.

BS: Cash flows to BS -$40, assets -$40. Debt -$40, liabilities -$40. BS balances.

Question 23

When would a company collect cash from a customer and not record it as revenue?

Answer 23

Companies that provide subscription or contract-based services will record deferred revenue when cash is received, and revenue will be recorded as the service is provided.

Question 24

If cash collected is not recorded as revenue, what happens to it?

Answer 24

It is recorded as deferred revenue on the BS, and recognized into revenue on the IS as the service is provided.

Question 25

What is the difference between AR and Deferred Revenue?

Answer 25

AR is where revenue has been recognized but cash has not been received.

Deferred revenue is where cash has been received but no revenue has been recorded.

Question 26

How long does it normally take for a company to collect its AR?

Answer 26

AR turnover is typically 30-60 days, but it can be higher for significant customers with ongoing relationships, and higher-end items.

Question 27

What is the difference between cash-based and accrual accounting?

Answer 27

Cash-based accounting recognizes revenue/expenses when cash is received/paid out.

Accrual accounting recognizes revenue/expenses when the service is provided/expense is incurred.

Question 28

If a customer pays for a TV with a credit card, what does this look like under cash-based vs. accrual accounting?

Answer 28

Cash-based: The inventory movement would be recorded as soon as the TV transfers, but revenue would not be recorded until cash is actually received (no AR).

Accrual: The inventory movement and revenue recognition would occur at the same time, with revenue being recorded against AR. Once cash is received from the credit card company, the AR would be reversed.

Question 29

When do you capitalize vs. expense a purchase?

Answer 29

If you expect to receive economic benefit beyond 1 year, you capitalize and then amortize over the useful life.

Question 30

Why do companies report both GAAP and non-GAAP earnings.

Answer 30

GAAP earnings includes non-cash accounting charges (amortization, SBC, losses etc.).

Non-GAAP earnings may be closer to the true cash flows of the business.

Question 31

A company has had positive EBITDA for 10 years but has just gone bankrupt. Why?

Answer 31

1. Company is spending too much on Capex - not reflected in EBITDA but requires cash.
2. Company is unable to meet its interest payments and defaults on its debt.
3. The company’s debt matures and it is unable to refinance due to a credit crunch. It therefore goes bankrupt as the debt becomes due.
4. It has significant contingent liabilities (e.g. litigation) that bankrupt the company when they are realized.

Question 32

Why does goodwill impairment happen and what does it mean?

Answer 32

Usually happens when the parent company reassesses the acquired company’s brand, customer list, IP, and considers it to be impaired (worth less than originally paid for).

Can also happen when a company discontinues a part of its operations and must impair the associated goodwill.

Question 33

Under what circumstances would goodwill increase?

Answer 33

Usually one of two scenarios:
1. The company gets acquired and goodwill increases as a result, or
2. The company performs another acquisition and adds the new acquiree’s goodwill to its current balance

Question 34

What is the difference between FIFO and LIFO?

Answer 34

LIFO: last in first out. If price of inventory is increasing, then COGS would be higher (and net income lower) and ending inventory lower.

FIFO: first in first out. If price of inventory is increasing, then COGS would be lower under FIFO (and net income higher), and ending inventory higher.

Vice versa with price of inventory decreasing.