Accounting Basic

Question 1

Walk me through the three financial statements?

Answer 1

Income statement, balance sheet, cash flow statement.

On your income statement, you have things like revenue expenses, net income.

On your balance sheet you have things like assets, liabilities, stockholders equity assets, cash, and accounts, receivable, inventory liabilities like accounts, payable, accrued expenses, notes, payable deferred revenue, and stockholders equity like common stock additional painting capital retained earnings.

the cash flow statement begins with net income. Adjust for non-cash expenses and working capital changes then you have cash flow from investing findings and activities at the end in the companies net change in cash.

Question 2

Give examples of major line items on each of the financial statements.

Answer 2

On your income statement, some major line items include revenue. Cost of good sold research and development, selling general and administrative operating income, pretax income and net income.

On your balance sheet you have things like cash, accounts receivable, inventory property, plant, and equipment accounts payable, accrued expenses, debt, and stockholders equity.

On your cash flow statement, you have things like net income depreciation and amortization other non-cash expenses stock based compensation changes in operating assets and liabilities cash flow from operations capital expenditures cash flow from investing sale or purchase of securities, dividends issued and cash flow from financing.

Question 3

How do the three statements link together?

Answer 3

Net income from the income statement flows into stock orders equity on the balance sheet and the top line of the cash flow statement. Net income is embedded in retained earnings net income minus dividends.

Changes to the balance sheet appear as working capital changes to the cash flow statement.

Investing and financing activities affect the balance sheet such as property plan and equipment debt and stock holders equity.

Cash and stockholders equity on balance sheet act as plugs with cash flowing in from the final line on the cash flow statement.

Question 4

One statement and why?

Answer 4

You would use the cash flow statement because it is a true picture of how much cash the company is actually generating independent of all non-cash expenses you might have.

the number one thing you care about when analyzing the overall financial health of any business is the companies cash flow.

Question 5

Let’s say, I could only look at two statements to assess a companies prospects which two would I use and why?

Answer 5

You would pick the income statement and balance sheet because you can create the cash flow statement from both of them.

Assuming that you have before, and after versions of the balance sheet that corresponded the same period as the income statement.

Question 6

Walk me through how depreciation going up by $10 would affect the statements?

Answer 6

Depreciation is an expense so on your income statement, operating income would decline by $10.

Assuming a 40% tax rate 10×40% equals $4.

10 -4 dollars equals six dollars net income would go down by six dollars.

Moving to your cash flow statement, net income at the top goes down by six.

$10 depreciation is a non-cash expense that gets added back so overall cash flow from operations goes up by four dollars.

Lastly looking at your balance sheet property plant and equipment goes down by $10 on the asset side because of depreciation cash is up by four dollars from the changes on the cash flow statement. Overall assets is down by six dollars net income fell by six dollars as well on the stock holders equity on the right side of the balance equation.

Question 7

If depreciation is a non-cash expense why does it affect the cash balance?

Answer 7

Although depreciation is a non-cash expense it is tax deductible since taxes are a cash expense depreciation affects cash by reducing the amount of taxes you pay.

Tax deductible because reduces amount of taxable income.

Question 8

Where does depreciation usually show up on the income statement?

Answer 8

It depends on what the company does. It could be embedded in cost of good sold or operating expenses no matter what depreciation always reduces pre-tax income.

Question 9

what happens when a accrued compensation earned not paid goes up by $10?

Answer 9

Assuming accrued compensation is now being recognized as an expense operating expenses on the income statement go up by $10.

Pretax income falls by $10.

Net income falls by six dollars assuming a 40% tax rate.

Moving to the cash flow statement, net income will be down by six.

Accrued compensation will increase cash flow by $10.

Overall, cash flow from operations is up by four dollars.

Net change in cash at the bottom is up by four dollars.

Looking at the balance sheet cash is up by four dollars assets up by four dollars accrued compensation is a liability so liabilities up $10 retained earnings down by six dollars due to net income it balances out.

Question 10

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

Answer 10

There will be no change to the income statement.

The cash flow statement inventory is an asset so that decreases your cash flow from operations by $10 as does the net change in cash at the bottom.

When your balance sheet under assets inventory is up $10 cash is down $10 changes cancel out assets still equal liabilities and stock equity.

Question 11

Why is the income statement not affected by changes in inventory?

Answer 11

The expense is only recorded when the goods associated with it are sold if it is just sitting in a warehouse, it does not count as a cogs or operating expense until the company manufactures it into a product and sell it.

Inventory up, cogs down gross profit up

Inventory down, cogs up gross profit down

Sold or adjusted affect cogs

Cost of sold inventory moved from balance sheet to income statement

Accrued account, principal manufactured, processed or sold.

Question 12

Let’s say Apple is buying $100 worth of new iPad factories with debt. How are all three statements affected at the start of year one before anything else happens?

Answer 12

At the start of year one before anything else has happened there would be no changes on apples, income statement yet factories depreciate appear on income statement as an expense later.

On your cash flow statement, additional investment in factories would show up under cash flow from investing as a net reduction in cash flow so cash flow is down by $100 so far.

Additional $100 worth of debt raised would show up as an addition to cash flow canceling out investment activity. This is represented in the cash flow from financing section.

Overall, cash number stays the same.

On your balance sheet additional $100 worth of factories in the property plant and equipment line so property plant and equipment up by $100 in assets up by $100.

On the other side debt is up by 100 as well so both sides balance.

Question 13

Now let’s go out one year to the start of year two assume the debt is high yield meaning risky so no principles paid off and assume an interest rate of 10% also assume the factories depreciate at a rate of 10% per year what happens?

Answer 13

After a year has passed, Apple must pay interest expense and must record the depreciation.

Operating income would decreased by $10 due to the 10% appreciation charge each year and the $10 in additional interest expense would decrease the pretax income by $20 altogether $10 from depreciation $10 from interest expense.

Now assuming a tax rate of 40% net income would fall by $12 you’re $20 times 40% equals $8
20 -8 equals 12.

Moving to your cash flow statement, net income would be down by $12 depreciation is a non-cash expense so you add it back in the end result is that cash flow from operations is down by two dollars.

That’s the only change on the cash flow statement so overall cash is down by two dollars.

On your balance sheet under assets cash is down by two and PPE is down by 10 due to the depreciation overall assets down by twelve.

On the other side since net income was down by $12 shareholders equities also down by $12 and both sides balance.

Remember, none of the debt under liabilities is changed since we assumed none of the debt is actually paid back.

Why doesn’t interest expense affect balance sheet?

It is an expense. It only shows on the income statement unless accrued or paid in advance. If it was accrued, it would be a current liability paid in advance current asset.

Question 14

At the start of year 3 the factories, all breakdown and the value of the equipment is written down to zero dollars. The loan must be paid back now walk me through the three statements?

Answer 14

After two years, the value of the factories is now $80 if we go with the 10% depreciation, per year assumption we write down that $80 in the three statements.

On the income statement, the $80 write down shows up in the pretax income line.

Assuming a 40% tax rate net income would decline by $48.

On the cash flow statement, net income is down by $48 but the write down is a non-cash expense so we added it back.

Cash flow from operations increases by $32.

There are no changes under cash flow from investing, but under cash flow from financing there is $100 charge for the loan payback. Cash flow from financing falls by $100 so net change in cash falls by $68.

On the balance sheet cash is down by $68 and PPE is down by $80 so assets have decreased by $148 altogether.

On the other side of the equation debt is down $100 since it was paid off and since net income was down by $48 shareholders equity is down by $48 as well together liabilities and stock holders equity are down by $148 so both sides balance.

Question 15

Now let’s look at a different scenario and assume Apple is ordering $10 of additional iPad inventory using cash on hand. They order the inventory but they have not manufactured or sold anything yet. What happens to three statements?

Answer 15

No changes to your income statement.

On your cash flow statement inventory is up $10 so cash flow from operations decreases by $10 no further changes so cash flow is down by $10.

On your balance sheet inventory up $10 cash down $10 so asset number stays the same and balance sheet remains in balance.

Question 16

Now let’s say they sell iPads for revenue of $20 at a cost of $10 walk me through the three statements?

Answer 16

On your income statement, revenue is up by $20 cost to get sold is up by $10. Gross profit is up by $10.

Operating income up by $10 pretax income up by $10

Assuming a 40% tax rate net income would be up by six dollars

On your cash flow statement net income up by six dollars inventory decreased by $10 just manufactured inventory into real iPads net addition to cash flow cash flow from operations up by $16 only changes on the cash flow statement so net changes up by $16.

On your balance sheet cash is up by $16 inventory is down by $10 assets are up by six dollars on the other side net income is up by six dollars to stock quarters equities up by six dollars both sides balance.

Question 17

Could you ever end up with negative stockholders equity? What does it mean?

Answer 17

Yes, if liabilities exceeds assets or if a company owes more than it owns.

Two common scenarios

Leveraged buyouts with dividend recapitalization. Means the owner of the company is taking out a large portion of its equity over leveraging usually in the form of cash, which can sometimes turn the number negative.

Think of dividend recapitalization as a loan to give gifts to your friend, even though you owed money.

It’s also like when a company issues new debt, then uses the proceeds from that debt to pay a special dividend to shareholders reducing the companies equity.

Can also happen if the company has been losing money consistently, and therefore has a declining retained earnings balance, which is a portion of stock holders equity.

It doesn’t mean anything in particular, but it can be a cause for concern and possibly demonstrate of the company is struggling.

Shareholders equity never turns negative immediately after an LBO it would only happen following a dividend recap or continued losses.

Question 18

What is working capital? How is it used?

Answer 18

Working capital = current assets - current liabilities.

If positive means a company can pay off its short-term liabilities with its short-term assets.

Often presented as a financial metric and its magnitude and sign negative or positive tells you whether or not the company is sound.

Bankers look at operating working capital more commonly and models and that is defined as

(Current assets - cash and cash equivalence) - (current liabilities - debt)

Point of operating working capital is to exclude items that relate to a companies, financing activities, cash, and debt from the calculation, levered or unlevered focus super operational.

Subtracting things not core to a company’s operations

Also known as operating assets - operating liabilities

Operating meaning current assets but subtracting items not related to day to day operations like marketable securities, short term investments, and cash where current assets includes such things

Question 19

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

Answer 19

Not necessarily, it depends on the type of company and the situation it could mean…

Some companies with subscription or long-term contracts often have negative working capital because of high deferred revenue balances.

Retail and restaurant companies like Amazon Walmart and McDonald’s often have negative working capital because customers pay upfront, they can use the cash generated to pay off their accounts payable rather than keeping a large cash balance on hand sign of business efficiency.

In other cases negative working capital could point to financial trouble or possible bankruptcy example when customers don’t pay quickly and upfront, and the company is carrying a high debt balance.

Question 20

Recently banks have been writing down their assets and taking huge quarterly losses, walk me through what happens on the three statements when there’s a write down of $100?

Answer 20

On the income statement, $100 write-down shows up on the pretax income line assuming a 40% tax rate net income will be down by $60.

A write down is when the value of an asset is reduced example the market value of an asset drops below book value it’s not predictable. It’s like a one time event.

It shows up on the pretax income line because it reduces the companies earnings before tax.

On the cash flow statement, net income will be down by $60.

A write down is a non-cash expense so add it back.

Cash flow from operations is up by $40 overall net change in cash will be up by $40.

On the balance sheet cash is up by $40 asset is down by $100 not clear what asset since question never stated specific asset to write down so overall assets is down by $60.

Net income is down by $60 shareholders equities down by $60 both sides balance.

Question 21

Walk me through $100 bail out of a company and how it affects the three statements?

Answer 21

First confirm what type of bail out this is debt? Equity? A combination?

Most common scenario here is an equity investment from the government. Here’s what happens…

No change to the income statement

On the cash flow statement, cash flow from financing goes up by $100 to reflect the government investment net change in cash will be up by $100.

Cash is up by $100 on the balance sheet so assets are up by $100

On the other side, shareholders equity goes up by $100 to make it balance.

Question 22

Walk me through $100 write-down of debt as in owed debt a liability on a company balance sheet and it’s effect on the three statements?

Answer 22

Counterintuitive decreasing the companies obligation

When a liability is written down, you record it as a gain on the income statement when an asset is written down, it is a loss.

Pretax income goes up by $100 due to this right down assuming a 40% tax rate net income goes up by $60 .

Basically preventing a future loss.

On the cash flow statement, net income is up by $60 subtract that debt right down cash flow from operations down by $40 lost and non-cash expense so overall net changes down by $40

On the balance sheet cash is down by $40 assets is down by $40 on the other side debt is down by $100 shareholders equity up by $60 due to net income liabilities and share equity down by $40 so it balances.

Question 23

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

Answer 23

Three examples come to mind…

Subscription services payment upfront revenue recognized over the sub period.

Cell phone carriers that sell annual contracts, gift cards, and vouchers

Magazine publishers at sell subscriptions, product warrants, cash received over warranty period

Companies that agreed to services in the future often collect cash upfront to ensure stable revenue. This makes investors happy as well since they can better predict the companies performance.

Only record revenue when you actually perform the services so the company would not record. Everything is revenue right away.

Other examples include software as a service (SAAS) companies that collect a years worth of subscriptions fees at the start if a subscription. But it can only recognize revenue monthly as the service is performed.

Zoom canvas, Microsoft HubSpot, adobe, etc.

Unique example stick company. Customer pays a deposit for a customer made stick tailored to height, flex curved grip, and more. This company will not recognize the revenue until the stick is made and delivered not when the deposit is received.

Question 24

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

Answer 24

Usually, it goes into deferred revenue or unearned revenue on the balance sheet, under liabilities companies obligation to deliver goods or services in the future

Overtime as the services are performed that deferred revenue balance becomes real revenue on the income statement and deferred revenue balance decreases.

On the financial statements, revenue will be understated as the delayed recognition affects the profitability of the business .

Temporarily held as liability until it is appropriately recognized as income

Question 25

What’s the difference between a counter receivable and the furred revenue?

Answer 25

Accounts receivable has not yet been collected in cash from customers asset

Deferred revenue has been collected liability

Accounts receivable represents how much revenue the company is waiting on

Deferred revenue represents how much is already been collected in cash but is waiting to record is revenue

Question 26

How long does it actually take for company to collect its accounts receivable balance?

Answer 26

Generally, the accounts receivable days are in 30 to 60 day ranges higher for companies selling high-end items lower for smaller lower transaction companies

Question 27

What’s the difference between cash based and accrual accounting?

Answer 27

Cash based recognizes revenues and expenses when cash is actually received or paid out cash hits account

Accrual recognizes revenue when collection is reasonably certain under gaap , generally accepted accounting principles after a customer has ordered the product and recognizes expenses when they are incurred rather than when they are paid out in cash incurred rather than earned most large companies use accrual because paying with credit cards and lines of credit is so prevalent these days

Small companies use or may use cash accounting to simplify their financial statements

timing of when revenue and expenses are recognized

Question 28

Let’s say customer pays for a TV with a credit card. What would this look like under cash based accounting versus accrual accounting?

Answer 28

Cash based revenue does not show up until the company charges the customer customers credit card receives authorization and deposit the funds and its bank account and then shows up as both revenue on the income statement and in cash on the balance sheet. There may be a delay in the processing.

Accrual shows up as revenue right away but goes to accounts receivable on the balance sheet instead of cash at first and once the cash is actually deposited in the companies bank account it would turn into cash.

Capitalization it means recognizing a cost as an asset allows company to spread cost over useful wife, lower annual expenses, higher net income policies vary by company delay full recognition of expenses provides a more accurate picture of a company’s financial health

Costs that are not very significant or for items that only provide benefits in short term immediately reduces net income and current period

Question 29

How do you decide when to capitalize rather than expense a purchase?

Answer 29

If the asset has a useful life of over one year, it is capitalized, put on the balance sheet rather than expense on the income statement.

It is depreciated, tangible assets, or amortized, intangible asset over a certain number of years

Purchases like factories, equipment, and land all last longer than a year therefore show up on the balance sheet

In terms of expensing employee salaries and the cost of manufacturing products cost of good sold only cover a short period of operations therefore show up on the income statement as normal expenses

Question 30

Why do companies report both gaap and non-gaap (pro forma) earnings?

Answer 30

These days, many companies have non-cash charges such as amortization of intangibles stock based compensation and deferred revenue write downs in their income statements.

Some argue that income statements under GAAP no longer reflect how profitable most companies truly are.

Non GAAP or pro forma earnings are almost always higher because these expenses are excluded footnote on financial statement mentions this exclude, irregular or noncash, expenses, acquisitions restructuring, one time balance sheet adjustments, smooth out high earnings volatility that can result from these conditions provide a clear picture.

Question 31

A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?

Answer 31

Several possibilities company is spending too much on capital expenditures these are not reflected at all an EBITDA but it could still be cash flow negative.

A company has high interest expense and is no longer able to afford its debt if the company is very levered.

The companies debt all matures on one date and it is unable to refinance it due to a credit crunch, and it runs out of cash completely when paying back the debt.

It has significant one time charges from litigation, and those are high enough to bankrupt the company.

EBITDA excludes investment in and depreciation of long-term assets interest in one time charges, and all of these could end up bankrupting the company.

High debt levels.

Poor cash flow EBITDA is a non-cash measure so could have positive EBITDA but negative cash flow. Non-cash in the sense that it adds back non-cash expenses to net income.

High capital expenditures changes in working capital, debt maturity, economic conditions, like a recession, large, one time expenses, legal fines, settlement costs, right downs, etc.

Question 32

Normally, Goodwill remains constant on the balance sheet. Why would it be impaired and what does Goodwill impairment mean?

Answer 32

Happens when a company has been acquired and the acquirer reassesses its intangible assets, like customers brand intellectual property and finds out their worth significantly less than they originally thought.

It often happens in acquisitions where the buyer overpaid for the seller and can result in a large net loss on the income statement.

Can also happen when a company discontinues part of its operations and must impair the associates. Goodwill. Don’t say this part.

Test for Goodwill impairment at least annually

Some things you can’t give a number

Intangible asset on balance sheet when company acquires another company for a price that exceeds the net value of acquired companies, assets and liabilities, brand name, customer base good customer relations, etc.

Example company A gets company B for $1 million, company B assets and liabilities are worth $800,000 Goodwill $200,000 drops to $150,000. Goodwill is impaired by $50,000 company A expenses on income statement.

Question 33

Under what circumstances would Goodwill increase?

Answer 33

Technically, Goodwill can increase if the company reassesses its value and finds that it is worth more, but that is rare. Usually what happens is one of two scenarios…

The company gets acquired or bought out and Goodwill changes as a result since it’s in accounting plug for the purchase price and an acquisition excess of the purchase price over FMV fair market value.

The company acquires another company and pays more than what it’s assets are worth. This is then reflected in the Goodwill number.

Question 34

Difference between LIFO and FIFO? Walk me through an example of how they differ?

Answer 34

Does not apply if outside the US IFRS does not permit the use of LIFO

LIFO stands for last in first out

FIFO stand for first and first out

Two different ways of reading the value of inventory and cost of good sold COGS

LIFO use the value of the most recent inventory additions for COGS

FIFO use the value of the oldest

Example starting inventory $100.10 units at $10 each

Add ten units each quarter twelve dollars each quarter fifteen dollars each and quarter to seventeen dollars each and quarter three twenty dollars each and quarter for quarter total a hundred twenty dollars quarter to total a hundred fifty dollars quarter three total a hundred and seventy dollars quarter for total $200

40 units throughout the year for $30 each, both LIFO and FIFO record 40 times $30 or $1200 annual revenue

LIFO 40 newest for COGS
200+170+150+120 = 640 COGS lower pretax and net income ending inventory value $100 lower

FIFO 40 oldest for COGS
100+120+150+170 = 540 COGS ending inventory value $100 higher

In general, if inventory is getting more expensive to purchase, LIFO will produce higher values for COGS and lower ending inventory values and vice versa if inventory is getting cheaper to purchase