Accounting (Basic)

Question 1

Walk me through the 3 financial statements.

Answer 1

• The 3 major financial statements are the Income Statement (I/S)‚ Balance Sheet (B/S) and the Cash Flow Statement (SCF).
• The I/S shows the company’s revenue and expenses over a period of time‚ and goes down to Net Income (NI)‚ the final line on the statement.
• The B/S shows the company’s Assets (its resources - such as Cash‚ Inventory‚ and PP&E) as well as its Liabilities (such as Debt and Accounts Payable) and Shareholders’ Equity (SE) at a specific point in time. Assets must equal Liabilities plus SE.
• The SCF begins with NI‚ adjusts for non-cash expenses and changes in operating assets and liabilities (working capital)‚ and then shows how the company has spent or received cash from Investing or Financing activities; at the end‚ you see the company’s net change in cash.

Question 2

Can you give me examples of major line items on each of the financial statements?

Answer 2

• INCOME STATEMENT: Revenue; Cost of Goods Sold (COGS); Selling‚ General & Administrative (SG&A) Expenses; Operating Income‚ Pre-Tax Income‚ Net Income.
• BALANCE SHEET: Cash‚ Accounts Receivable (A/R)‚ Inventory‚ Plants‚ Property & Equipment (PP&E)‚ Accounts Payable‚ Accrued Expenses‚ Debt‚ Shareholders’ Equity (SE)
• CASH FLOW STATEMENT: Cash Flow from Operations (CFO) - Net Income‚ Depreciation & Amortization (D&A)‚ Stock-Based Compensation‚ Changes in Operating Assets & Liabilities; Cash Flow from Investing (CFI) - Capital Expenditures (CapEx)‚ Sale of PP&E‚ Sale/Purchase of Investments; Cash Flow from Financing (CFF) - Dividends Issued‚ Debt Raised/Paid Off‚ Shares Issued/Repurchased

Question 3

How do the 3 statements link together?

Answer 3

• To tie the 3 statements together‚ NI from the I/S becomes the top line of the SCF.
• Then you add back any non-cash charges such as D&A to this NI number.
• Next‚ changes to operational B/S items appear and either reduce or increase cash flow depending on whether they are Assets or Liabilities and whether they go up or down. That gets you to CFO.
• Now you take into account investing and financing activities and changes to items like PP&E and Debt on the B/S; those will increase or decrease cash flow‚ and at the bottom you get net change in cash.
• On the B/S for the end of this period‚ Cash at the top equals the beginning Cash number (from the start of this period)‚ plus the net change in cash from the SCF.
• On the other side‚ NI flows into SE to make the B/S balance.
• At the end‚ Assets must always equal Liabilities plus SE.

Question 4

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?

Answer 4

• You would use the SCF b/c it gives a true picture of how much cash the company is actually generating - the I/S is misleading b/c it includes non-cash expenses and excludes actual cash expenses such as Capital Expenditures.
• And that’s the #1 thing you care about when analyzing the financial health of any business - its true cash flow.

Question 5

Let’s say I could only look at 2 statements to assess a company’s prospects - which 2 would I use and why?

Answer 5

You would pick the I/S and B/S because you can create the SCF from both of those (assuming that you have the “Beginning” and “Ending” Balance Sheets that correspond to the same period the I/S is tracking.

Question 6

Let’s say I have a new‚ unknown item that belongs on the Balance Sheet. How can I tell whether it should be an Asset or a Liability?

Answer 6

• An Asset will result in additional cash or potential cash in the future - think about how Investments or A/R will result in a direct cash increase‚ and how Goodwill or PP&E may result in an indirect cash increase in the future.
• A Liability will result in less cash or potential cash in the future - think about how Debt or A/P will result in a direct cash decrease‚ and how something like Deferred Revenue will result in an indirect cash decrease as you recognize additional taxes in the future from recognizing revenue.
• Ask what direction cash will move in as a result of this new item and that tells you whether it’s an Asset or Liability.

Question 7

How can you tell whether or not an expense should appear on the Income Statement?

Answer 7

Two conditions must be true for an expense to appear on the I/S:
1. It must correspond to something in the current period
2. It must be tax-deductible.
• Employee compensation and marketing spending‚ for example‚ satisfy both conditions.
• Depreciation and Interest Expense also meet both conditions - Depreciation only represents the “loss in value” of PP&E (or to be more technically precise‚ the allocation of the investment in PP&E) in the current period you’re in.
• Repaying debt principal does NOT satisfy both of these conditions b/c it is not tax-deductible.
• ADV. NOTE: Technically‚ “tax-deductible” here means “deductible for BOOK tax purposes” (i.e. only the tax number that appears on the company’s I/S).

Question 8

Let’s say that you have a non-cash expense (Depreciation or Amortization for example) on the Income Statement. Why do you add back the entire expense on the Cash Flow Statement?

Answer 8

• Because you want to reflect that you’ve saved on taxes with the non-cash expense.
• Let’s say you have a non-cash expense of $10 and a tax rate of 40%. Your NI decreases by $6 as a result… but then you add back the entire non-cash expense of $10 on the SCF so that your cash goes up by $4.
• That increase of $4 reflects the tax savings from the non-cash expense. If you just added back the after-tax expense of $6 you’d be saying‚ “This non-cash expense has no impact on your taxes or cash balance.”

Question 9

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

Answer 9

• If the purchase corresponds to an Asset with a useful life of over 1 year‚ it is capitalized (put on the B/S rather than shown as an expense on the I/S). Then it is Depreciated (tangible assets) or Amortized (intangible assets) over a certain number of years.
• Purchases like factories‚ equipment and land all last longer than a year and therefore show up on the B/S. Employee salaries and the cost of manufacturing products (COGS) only “last” for the current period and therefore show up on the I/S as normal expenses instead.
• Note that even if you’re paying for something like a multi-year lease for a building‚ you would NOT capitalize it unless you own the building and pay for the entire building in advance.

Question 10

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

Answer 10

Although Depreciation is a non-cash expense‚ it is tax-deductible. Therefore‚ an increase in Depreciation will reduce the amount of taxes you pay‚ which boosts your cash balance. The opposite happens if Depreciation decreases.

Question 11

Where does Depreciation usually appear on the Income Statement?

Answer 11

It could be a separate line item‚ or it could be embedded in COGS or Operating Expenses - each company does it differently. Note that the end result for accounting questions is the same: Depreciation always reduced Pre-Tax Income.

Question 12

Why is the Income Statement not affected by Inventory purchases?

Answer 12

The expense of purchasing Inventory is ONLY recorded on the I/S when the goods associated with it have been manufactured and sold - so if it’s just sitting in a warehouse‚ it does not count as Cost of Goods Sold (COGS) until the company manufactures it into a product and sells it.

Question 13

Debt repayment shows up in Cash Flow from Financing on the Cash Flow Statement. Why don’t interest payments also show up there? They’re a financing activity!

Answer 13

• The difference is that interest payments correspond to the current period and are tax-deductible‚ so they have already appeared on the I/S. Since they are a true cash expense and already appeared on the I/S‚ showing them on the SCF would be double-counting them and would be incorrect.
• Debt repayments are a true cash-expense but they do NOT appear on the I/S‚ so we need to adjust for them on the SCF.
• If something is a true cash expense and it has already appeared on the I/S‚ it will NEVER appear on the SCF unless we are re-classifying it - b/c you have already factored in its cash impact.

Question 14

What’s the difference between Accounts Payable and Accrued Expenses?

Answer 14

• Mechanically‚ they are the same: they’re Liabilities on the B/S used when you’ve recorded an I/S expense for a product/service you have received‚ but have not yet paid for in cash. They both affect the statements in the same way as well.
• The difference is that A/P is mostly for one-time expenses with invoices‚ such as paying for a law firm‚ whereas Accrued Expenses is for recurring expenses without invoices‚ such as employee wages‚ rents‚ and utilities.

Question 15

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

Answer 15

• Typically this happens when the customer pays upfront‚ in cash‚ for months or years of a product/service‚ but the company hasn’t delivered it yet. You see this in web-based subscription software‚ cell phone carriers that sell annual contracts‚ and magazine publishers that sell subscriptions.
• You only record revenue when you actually deliver the products/services - so the company does not record cash collected as revenue right away.

Question 16

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

Answer 16

• It goes into the Deferred Revenue balance on the B/S under Liabilities.
• Over time‚ as the services or products are delivered‚ the Deferred Revenue balance turns into real revenue on the I/S and the Deferred Revenue balance decreases.

Question 17

Deferred Revenue reflects cash that we’ve already collected upfront for a product/service we haven’t delivered yet. Why is it a Liability? That’s great for us!

Answer 17

• Remember the definitions of Assets and Liabilities: an Asset results in more future cash and a Liability results in less future cash.
• Think about how Deferred Revenue works: not only is the burden on us to deliver the product/service in question‚ but we are also going to pay additional taxes and possibly recognize additional future expenses when we record it as real revenue.
• It’s counter-intuitive‚ but that is why Deferred Revenue is a liability: it implies additional future expenses.

Question 18

So what’s the difference between Accounts Receivable and Deferred Revenue? They sound similar.

Answer 18

There are 2 main differences:
1. A/R has NOT yet been collected in cash from customers‚ whereas Deferred Revenue has been.
2. A/R is for a product/service that the company has ALREADY delivered but hasn’t been paid for yet‚ whereas Deferred Revenue is for a product/service the company has NOT yet delivered.
• A/R is an Asset b/c it implies additional future cash whereas Deferred Revenue is a Liability b/c it implies the opposite.

Question 19

How long does it usually take for a company to collect its Accounts Receivable balance?

Answer 19

Generally the Accounts Receivable Days are in the 30-60 day range‚ though it can be higher for companies selling higher-priced items and it might be lower for companies selling lower-priced items with cash payments only.

Question 20

How are Prepaid Expenses and Accounts Payable different?

Answer 20

It’s similar to the difference between A/R and Deferred Revenue:

1. Prepaid Expenses have already been paid out in cash‚ but haven’t yet shown up on the I/S‚ whereas A/P haven’t been paid out in cash but have shown up on the I/S.
2. Prepaid Expenses are for product/services that have not yet been delivered to the company‚ whereas A/P is for products/services that have already been delivered.

Question 21

You’re reviewing a company’s Balance Sheet and you see an “Income Taxes Payable” line item on the Liabilities side. What is this?

Answer 21

• Income Taxes Payable refers to normal income taxes that accrue and are then paid out in cash‚ similar to Accrued Expenses‚ but for taxes instead.
• Example: A company pays corporate income taxes in cash once every 3 months. But they also have monthly I/S where they record income taxes‚ even if they haven’t been paid out in cash yet.
• Those taxes increase the Income Taxes Payable account until they are paid out in cash‚ at which point Income Taxes Payable decreases.

Question 22

You see a “Noncontrolling Interest” (AKA Minority Interest) line item on the Liabilities side of a company’s Balance Sheet. What does this mean?

Answer 22

• If you own over 50% but less than 100% of another company‚ this refers to the portion you DO NOT OWN.
• Example: Another company is worth $100. You own 70% of it. Therefore‚ there will be a Noncontrolling Interest of $30 on your B/S to represent the 30% you do not own.

Question 23

You see an “Investments in Equity Interest” (AKA Associate Companies) line item on the Assets side of a firm’s Balance Sheet. What does this mean?

Answer 23

• If you own over 20% but less than 50% of another company‚ this refers to the portion that you DO OWN.
• Example: Another company is worth $100‚ you own 25% of it. Therefore‚ there will be an “Investments in Equity Interests” line item of $25 on your B/S to represent the 25% that you own.

Question 24

Could you ever negative Shareholders’ Equity? What does it mean?

Answer 24

Yes‚ it is common in 2 scenarios:
1. Leveraged Buyouts w/ dividend recapitalizations - it means that the owner of the company has taken out a large portion of its equity (usually in the form of cash)‚ which can sometimes turn the number negative.
2. It can also happen if the company has been losing money consistently and therefore has declining Retained Earnings balance‚ which is a portion of SE.
• It doesn’t “mean” anything in particular‚ but it might demonstrate that the company is struggling.
• NOTE: The Equity Value (AKA Market Cap) is different from SE and that Equity Value can NEVER be negative.

Question 25

What is Working Capital? How is it used?

Answer 25

Working Capital = Current Assets - Current Liabilities
• If it’s positive‚ it means a company can pay off its short-term Liabilities with its short-term Assets. It is often presented as a financial metric and its magnitude and sign (negative or positive) tells you whether or not the company is “sound.”
• You use Operating Working Capital more commonly in finance‚ and that is defined as (Current Assets Excluding Cash & Investments) - (Current Liabilities Excluding Debt)
• The point of Operating Working Capital is to exclude items that relate to a company’s financing and investment activities - Cash‚ Investments‚ and Debt - from the calculation.
• “Changes in Working Capital” more commonly called “Changes in Operating Assets and Liabilities) also appears on the SCF in CFO and tells you how these operationally-related B/S items change over time.

Question 26

“Short-Term Investments” is a Current Asset - should you count it in Working Capital?

Answer 26

• No. If you wanted to be technical‚ you could say that it should be included in “Working Capital‚” as define‚ but left out of “Operating Working Capital.”
• But the truth is that no one lists Short-Term Investments in this section b/c Purchases and Sales of Investments are considered investing activities‚ NOT operational activities.
• “Working Capital” is an imprecise idea and we prefer to say “Operating Assets and Liabilities” b/c that’s a more accurate way to describe the concept of operationally-related B/S items - which may sometimes be Long-Term Assets or Long-Term Liabilities (e.g. Deferred Revenue).

Question 27

What does negative (Operating) Working Capital mean? Is that a bad sign?

Answer 27

Not necessarily. It depends on the type of company and the specific situation - here are a few different things it could mean:

1. Some companies with subscriptions or longer-term contracts often have negative Working Capital b/c of high Deferred Revenue balances.
2. Retail and restaurant companies like Amazon‚ Wal-Mart‚ and McDonald’s often have negative Working Capital‚ b/c customers pay upfront‚ but they wait weeks or months to pay their suppliers - this is a sign of business efficiency and means that they have a healthy cash flow.
3. In other cases‚ negative Working Capital could point to financial trouble or possible bankruptcy (for example‚ when the company owes a lot of money to suppliers and cannot pay with cash on-hand).

Question 28

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

Answer 28

• Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out; accrual accounting recognizes revenue when collection is reasonably certain (i.e. after an invoice has been sent to the customer and the customer has a track record of paying on time) and recognizes expenses when they are incurred rather than when they are paid out in cash.
• All large companies use accrual accounting b/c it more accurately reflects the timing of revenue and expenses; small businesses may use cash-based accounting to simplify their financial statements (you no longer need a Cash Flow Statement if everything is cash-based).

Question 29

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

Answer 29

• Under cash-based accounting‚ the revenue would not show up until the company charges the customer’s credit card‚ receives authorization‚ and deposits the funds in its bank account - at which point it would add to Revenue on the I/S (and Pre-Tax Income‚ Net Income‚ etc.) and Cash on the B/S.
• Under accrual accounting‚ it would show up as Revenue right away but instead of appearing in Cash on the B/S‚ it would go into A/R at first. Then‚ once the cash is actually deposited in the company’s bank account‚ it would move into the Cash line item and A/R would go down.

Question 30

Why do companies report GAAP or IFRS earnings‚ AND non-GAAP/ non-IFRS (or “Pro-Forma”) earnings?

Answer 30

• Many companies have non-cash charges such as Amortization and Intangibles‚ Stock-Based Compensation‚ and Write-Downs on their Income Statements‚ all of which negatively impact their Net Income.
• Companies therefore report alternative “Pro Forma” metrics that exclude these expenses and paint a more favorable picture of their earnings‚ under the argument that these metrics better represent “true cash earnings.”

Question 31

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

Answer 31

There are several possibilities:
1. The company is spending too much CapEx - these are not reflected in EBITDA but represent true cash expenses‚ so CapEx alone could make the company cash flow-negative.
2. The company has high Interest Expense and is no longer able to afford its Debt.
3. The company’s Debt all matures on one date and it is unable to refinance due to a “credit crunch” - and it runs out of cash when paying back the Debt.
4. It has significant one-time charges (from litigation‚ for example) that have been excluded from EBITDA and those are high enough to bankrupt the company.
• Remember‚ EBITDA excludes investments in (and Depreciation of) Long-Term Assets‚ Interest‚ and Non-Recurring Charges - and any one of those could represent massive cash expenses.

Question 32

Normally Goodwill remains constant on the Balance Sheet - why would it be impaired and what does Goodwill Impairment mean?

Answer 32

• Usually this happens when a company buys another one and the acquirer reassess what it really got out of the deal - customer relationships‚ brand name‚ and intellectual property - and finds that those “Assets” are worth significantly less than they originally thought.
• It often happens in acquisitions where the buyer “overpaid” for the seller and it can result in extremely negative Net Income on the I/S.
• It can also happen when a company discontinues part of its operations and must impair the associated Goodwill.

Question 33

Walk me through how Depreciation going up by $10 would affect the statements.

Answer 33

• I/S: Operating Income and Pre-Tax Income would decline by $10 and‚ assuming a 40% tax rate‚ NI would go down by $6.
• SCF: The NI at the top goes down by $6‚ but the $10 Deprecation is a non-cash expense that gets added back‚ so overall CFO goes up by $4. There are no changes elsewhere‚ so the overall Net Change in Cash goes up by $4.
• B/S: PP&E goes down by $10 on the Assets side b/c of the Depreciation and Cash is up by $4 from the changes on the SCF. Overall‚ Assets is down by $6‚ Since NI fell by $6 as well‚ SE on the Liabilities & Equity side is down by $6 and both sides of the B/S balance.
• Intuition: We save on taxes with any non-cash charge‚ including Depreciation.

Question 34

What happens when Accrued Expenses increases by $10

Answer 34

For this question‚ remember that Accrued Expenses are recognized on the I/S but haven’t been paid out in cash yet. So this could correspond to payment being set aside for an employee‚ but not actually the employee in cash yet.
• I/S: Operating Income and Pre-Tax Income fall by $10‚ and NI falls by $6 (assuming a 40% tax rate).
• SCF: NI is down by $6‚ and the increase in Accrued Expenses will increase Cash Flow by $10‚ so overall CFO is up by $4 and the Net Change in Cash at the bottom is up by $4.
• B/S: Cash is up by $4 as a result‚ so Assets is up by $4. On the Liabilities & Equity side‚ Accrued Expenses is a Liability‚ so Liabilities is up by $10 and SE (Retained Earnings) is down by $6 due to the NI decrease‚ so both sides balance.
• Intuition: We record an additional expense and save on taxes with it‚ but that expense hasn’t been paid in cash yet‚ so our cash balance is actually up.

Question 35

What happens when Accrued Expenses decreases by $10 (i.e. it’s now paid out in the form of cash)? Do NOT take into account cumulative changes from previous increases in Accrued Expenses.

Answer 35

Assuming that you are not taking into account any previous increases (confirm this):
• I/S: There are no changes.
• SCF: The change in Accrued Expenses in the CFO section is negative $10 b/c you pay it out in cash‚ and so the cash at the bottom decreases by $10.
• B/S: Cash is down by $10 on the Assets side and Accrued Expenses is down by $10 on the other side‚ so it balances.
• Intuition: This is a simple cash payout of previously recorded expenses.

Question 36

Accounts Receivable increases by $10. Walk me through the 3 statements.

Answer 36

If A/R increases by $10‚ it means that we’ve recorded revenue of $10 but haven’t received it in cash yet. For example‚ a customer has ordered a $10 product from us and we’ve delivered it‚ but we are still waiting on cash payment.
• I/S: Revenue is up by $10 and so is Pre-Tax Income‚ which means that Net Income is up by $6 assuming a 40% tax rate.
• SCF: NI is up by $6 but the A/R increase is a reduction in cash (since we don’t have the cash yet)‚ so we need to subtract $10‚ which results in cash at the bottom being down by $4.
• B/S: On the Assets side‚ Cash is down by $4 and A/R is up by $10‚ so the Assets side is up by $6. On the other side‚ SE is up by $6 b/c NI has increased by $6. Both sides balance.
• Intuition: When A/R increases‚ it means that we’ve paid taxes on additional revenue but haven’t received any of that revenue in cash yet‚ so our cash balance decreases by the additional amount in taxes we’ve paid.

Question 37

Prepaid Expenses decreases by $10. Walk me through the statements. Do NOT take into account cumulative changes from previous increases in Prepaid Expenses.

Answer 37

When Prepaid Expenses “decrease‚” it means that expenses are now recognized on the I/S. For example‚ we’ve previously paid for an insurance policy in cash and have now recognized that same expense on the I/S.
• I/S: Pre-Tax Income is down by $10 and NI is down by $6.
• SCF: NI is down by $6 but since Prepaid Expense is an Asset‚ a decrease of $10 results in an increase of $10 in cash. At the bottom of the SCF‚ cash is up by $4 as a result.
• B/S: On the Assets side‚ Cash is up by $4 and Prepaid Expense is down by $10‚ so the Assets side is down by $6 overall. On the other side‚ SE is down by $6 b/c of the reduced NI‚ so both sides balance.
• Intuition: Here‚ we’re losing NI and paying additional taxes‚ but we’ve already paid out these expenses in cash previously. So our Cash balance goes up rather than down‚ despite the additional I/S expenses.

Question 38

What happens when Inventory goes up by $10‚ assuming you pay for it with cash?

Answer 38

• I/S: No changes.
• SCF: Inventory is an Asset so that reduces CFO - it goes down by $10‚ as does the Net Change in Cash at the bottom.
• B/S: On the Assets side‚ Inventory is up by $10 but Cash is down by $10‚ so the changes cancel out and Assets still equals Liabilities & Equity.
• Intuition: We’ve spent cash to buy Inventory‚ but haven’t manufactured or sold anything yet.

Question 39

A company sells some of its PP&E for $120. On the Balance Sheet‚ the PP&E is worth $100. Walk me through how the 3 statements change.

Answer 39

• I/S: You record a Gain of $20 ($120 - $100)‚ which boosts Pre-Tax Income by $20. At a 40% tax rate‚ Net Income is up by $12.
• SCF: Net Income is up by $12‚ but you need to subtract out that Gain of $20‚ so CFO is down by $8. Then‚ in CFI‚ you record the entire amount of proceeds from the sale‚ $120‚ so that section is up by $120. At the bottom of the SCF‚ cash is therefore up by $112.
• B/S: Cash is up by $112‚ but PP&E is down by $100 since we’ve sold it‚ so the Assets side is up by $12. The other side is up by $12 as well‚ since SE is up by $12 due to the NI increase.
• Intuition: Gains and Losses are not non-cash‚ but they are re-classified on the SCF. The cash increase here simply reflects the after-tax profit from the Gain - if we had sold the PP&E at its Balance Sheet value‚ there would be no change on the I/S.

Question 40

Walk me through what happens on the 3 statements when there’s an Asset Write-Down of $100.

Answer 40

• I/S: The $100 Write-Down reduces Pre-Tax Income by $100. With a 40% tax rate‚ NI declines by $60.
• SCF: NI is down by $60‚ but the Write-Down is a non-cash expense‚ so we add it back - and therefore CFO increases by $40. Cash at the bottom is up by $40.
• B/S: Cash is now up by $40 and an Asset is down by $100 (it’s not clear which Asset since the question never stated it). Overall‚ the Assets side is down by $60. On the other side‚ since NI was down by $60‚ SE is also down by $60 - and both sides balance.
• Intuition: The same as any other non-cash charge: we save on taxes‚ so our Cash goes up‚ and something on the B/S changes in response.

Question 41

Explain what happens on the 3 statements when a company issues $100 worth of shares to investors.

Answer 41

• I/S: No changes (since this doesn’t affect taxes and since the shares will be around for years to come).
• SCF: CFF is up by $100 due to this share issuance‚ so cash at the bottom is up by $100.
• B/S: Cash is up by $100 on the Asset’s side and SE (Common Stock & APIC) is up by $100 on the other side to balance it.
• Intuition: This one does not affect taxes and does not correspond to the current period‚ so it doesn’t show up on the I/S - just like similar items‚ all that changes is Cash and then something else on the B/S.

Question 42

Let’s say instead of issuing $100 worth of stock to investors‚ the company issues $100 worth of stock to employees in the form of Stock-Based Compensation. What happens?

Answer 42

• I/S: You need to record this as an additional expense b/c it’s now a tax-deductible and a current expense‚ Pre-Tax Income falls by $100 and NI falls by $60 (assuming a 40% tax rate).
• SCF: NI is down by $60 but you add back the SBC of $100 since it’s a non-cash charge‚ so cash at the bottom is up by $40.
• B/S: Cash is up by $40 on the Assets side. On the other side‚ Common Stock & APIC is up by $100 due to the SBC‚ but RE is down by $60 due to the reduced NI‚ so SE is up by $40 and both sides balance.
• Intuition: This is a non-cash charge‚ so like all non-cash charges it impacts the I/S and affects one B/S item in addition to Cash and RE - in this case‚ it flows into Common Stock & APIC b/c that one reflects the market value of stock at the time the stock was issued. The cash increase here simply reflects the tax savings.

Question 43

A company decides to issue $100 in Dividends - how do the 3 statements change?

Answer 43

• I/S: No changes. Dividends count as a financing activity and are not tax-deductible‚ so they never appear on the I/S.
• SCF: CFF is down by $100 due to the Dividends‚ so cash at the bottom is down by $100.
• B/S: Cash is down by $100 on the Assets side‚ and SE (RE) is down by $100 on the other side‚ so both sides balance.
• Intuition: This is another non-operational CFS/BS item‚ so it is a simple use of cash and nothing else changes.

Question 44

A company has recorded $100 in income tax expense on its Income Statement. All $100 of it is paid‚ in cash‚ in the current period. Now we change it and only $90 of it is paid in cash‚ with $10 being deferred to future periods. How do the statements change?

Answer 44

• I/S: Nothing changes. Both Current and Deferred Taxes are recorded simply as “Taxes” and NI remains the same. NI changes only if the total amount of taxes changes.
• SCF: NI remains the same but we add back the $10 worth of Deferred Taxes in CFO - no other changes‚ so cash at the bottom is up by $10.
• B/S: Cash is up by $10 and so the entire Assets side is up by $10. On the other side‚ the DTL is up by $10 and so both sides balance.
• Intuition: Deferred Taxes saves us cash in the current period‚ at the expense of additional cash taxes in the future.

Question 45

Walk me through a $100 “bailout” of a company and how it affects the 3 statements.

Answer 45

First‚ confirm what type of “bailout” this is - Debt? Equity? A combination? The most common scenario here is an Equity (Preferred Stock) investment from the government‚ so here’s what happens:
• I/S: No changes.
• SCF: CFF goes up by $100 to reflect this new investment‚ so the Net Change in Cash is up by $100.
• B/S: Cash is up by $100 so the Assets side is up by $100; on the other side‚ SE goes up by $100 to make it balance (Common Stock & APIC for a normal equity investment or Preferred Stock for preferred).
• Intuition: It’s the same as a normal stock issuance: no I/S changes b/c nothing affects the company’s taxes.

Question 46

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.

Answer 46

This one is counter-intuitive. When a Liability is written down‚ you record it as an addition on the I/S (with an asset write-down‚ it’s a subtraction).
• I/S: Pre-Tax Income goes up by $100‚ and assuming a 40% tax rate‚ NI is up by $60.
• SCF: NI is up by $60‚ but we need to subtract that Debt Write-Down b/c it was non-cash - CFO is down by $40‚ and Cash is down by $40 at the bottom.
• B/S: Cash is down by $40 so the Assets side is down by $40. On the other side‚ Debt is down by $100 but SE is up by $60 b/c the NI was up by $60 - so Liabilities & SE is down by $40 and both sides balance.
• Intuition: One way to think about this is that writing down Assets is “bad” for us b/c it reduces our ability to generate future cash flow‚ but writing down Liabilities is “good” b/c it reduces our future expenses (sort of). I don’t recommend presenting it like that in an interview.

Question 47

If writing down Liabilities boosts Net Income‚ why don’t companies just do it all the time? It helps them out!

Answer 47

• This is like asking‚ “If declaring bankruptcy helps you relieve your obligations‚ why not do it whenever you rack up debt?”
• And the answer is similar: b/c it may help in the short-term‚ but in the long-term it hurts the company’s credibility and ability to borrow in the future. If a company continually writes down its Liabilities‚ investors will stop trusting it - and the inability to borrow again will hurt it far more than a reduced NI would.

Question 48

What’s the difference between LIFO and FIFO? Can you walk me through an example of how they differ?

Answer 48

• First‚ note that this question does not apply to you if you’re outside the US b/c IFRS does not permit the use of LIFO.
• LIFO stands for “Last-In‚ First-Out” and FIFO stands for “First-In‚ First-Out” - they are 2 different ways of recording the value of Inventory and the Cost of Goods Sold (COGS).
• With LIFO‚ you use the value of the most recent Inventory additions for COGS‚ but w/ FIFO‚ you use the value of the oldest Inventory additions for COGS.
• Here’s an example: let’s say your starting Inventory balance is $100 (10 units valued at $10 each). You add 10 units each quarter for $12 each in Q1 ($120 total)‚ $15 each in Q2 ($150 total)‚ $17 each in Q3 ($170 total)‚ and $20 each in Q4 ($200 total).
• You sell 40 of these units throughout the year for $30 each. In both LIFO and FIFO‚ you record 40 * $30 = $1200 for the annual revenue.
• The difference is that in LIFO‚ you would use the 40 most recent Inventory purchase values ($120 + $150 + $170 + $200) for the COGS‚ whereas in FIFO you would use the 40 oldest Inventory values ($100 + $120 + $150 + $170) for COGS.
• As a result‚ the LIFO COGS would be $640 and FIFO COGS would be $540‚ so LIFO would also have a lower Pre-Tax Income and NI. The ending Inventory value would be $100 higher under FIFO and $100 lower under LIFO.
• If Inventory is getting more expensive to purchase‚ LIFO will produce higher value for COGS and lower ending Inventory values and vice versa if Inventory is getting cheaper to purchase.

Question 49

Let’s say Apple is buying $100 worth of new iPad factories with debt. How are all 3 statements affected at the start of “Year 1‚” before anything else happens?

Answer 49

• I/S: At the start of “Year 1‚” there are no changes yet.
• SCF: The $100 worth of CapEx would show up under CFI as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of Debt raised would up as an addition to CFF‚ canceling out the investment activity. So the cash number stays the same‚ for now.
• B/S: There is now an additional $100 worth of factories‚ so PP&E is up by $100 and Assets is therefore up by $100. On the other side‚ Debt is up by $100‚ so the entire other side is up by $100 and both sides balance.

Question 50

• Let’s say Apple is buying $100 worth of new iPad factories with debt. Now let’s go out one year‚ to the start of Year 2. Assume the Debt is high-yield‚ so no principal is paid off‚ and assume an interest rate of 10%. Also assume the factories Depreciate at a rate of 10% per year. What happens now?
• Assume that we have already factored in the changes from Part 1 and are only tracking what happens AFTER those have taken place.

Answer 50

• I/S: Operating Income decreases by $10 due to the 10% Depreciation charge each year‚ and the $10 in additional Interest Expense decreases the Pre-Tax Income by $20 altogether ($10 from the Depreciation and $10 from Interest Expense). Assuming a tax rate of 40%‚ NI falls by $12.
• SCF: NI at the top is down by $12. Depreciation is a non-cash expense‚ so you add it back and the end result is that CFO is down by $2. That’s the only change on the SCF‚ so overall cash is down by $2.
• B/S: On the Assets side‚ Cash is down by $2 and PP&E is down by $10 due to the Depreciation‚ so overall the Assets side is down by $12. On the other side‚ NI was down by $12‚ SE is also down by $12 and both sides balance.
• Remember that the Debt number itself does not change since we’ve assumed that nothing is paid back.

Question 51

Let’s say Apple is buying $100 worth of new iPad factories with debt. At the end of Year 2‚ the factories all break down and their value is written down to $0. The loan must also be paid back now. Walk me through how the 3 statements change ONLY from the start of Year 2 to the end of Year 2.

Answer 51

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 on the 3 statements. Also‚ don’t forget about the Interest Expense - it still needs to be paid in Year 2.
• I/S: We have $10 worth of Depreciation and then the $80 Write-Down. We also have $10 of additional Interest Expense‚ so Pre-Tax Income is down by $100. NI is down by $60 at a 40% tax rate.
• SCF: NI is down by $60 but the Write-Down and Depreciation are both non-cash expenses‚ so we add them back and cash flow is up by $30 so far. There are no changes under CFI‚ but under CFF there is a $100 charge for the loan payback - so CFF falls by $100. Overall cash at the bottom decreases by $70.
• B/S: Cash is now down by $70‚ and PP&E has decreased by $90‚ so the Assets side is down by $160. On the other side‚ Debt is down by $100 since it was paid off‚ and since NI was down by $60‚ SE is down by $60. Both sides are down by $160 and balance.

Question 52

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 the 3 statements?

Answer 52

• I/S: No changes.
• SCF: Inventory is up by $10‚ so CFO decreases by $10. There are no further changes‚ so overall Cash is down by $10.
• B/S: Inventory is up by $10 and Cash is down by $10 so the Assets number stays the same and the B/S remains in balance.

Question 53

Let’s say Apple sells iPads for revenue of $20‚ at a cost of $10. Walk me through the 3 statements under this scenario.

Answer 53

• I/S: Revenue is up by $20 and COGS is up by $10‚ so Gross Profit‚ Operating Income‚ and Pre-Tax Income are all up by $10. Assuming a 40% tax rate‚ NI is up by $6.
• SCF: NI at the top is up by $6 and Inventory has decreased by $10 (since we just manufactured the Inventory into real iPads)‚ which is a net addition to cash flow - so CFO is up by $16 overall. These are the only changes on the CFS‚ so cash at the bottom is up by $16.
• B/S: Cash is up by $16 and Inventory is down by $10‚ so the Assets side is up by $6 overall. On the other side‚ NI was up by $6‚ so SE is up by $6 and both sides balance.
• Intuition: This simply reflects the sale of products at a certain cost‚ and the after-tax profit from that. The only tricky part is how Cash increases by $16‚ not $6 - that just reflects the “release” in net working capital you get from selling off the Inventory.

Question 54

• A company raises $100 worth of Debt‚ at 5% interest and 10% yearly principal repayment‚ to purchase $100 worth of Short-Term Securities with 10% interest attached.
• Walk me through how the 3 statements change IMMEDIATELY AFTER this initial purchase.

Answer 54

• I/S: No changes yet.
• SCF: The $100 Purchase of Short-Term Securities shows up as a reduction of cash flow under CFI‚ and the $100 Debt raised shows up as a $100 increase under CFF. Cash at the bottom is unchanged.
• B/S: Short-Term Securities on the Assets side is up by $100‚ and Debt on the Liabilities side is up by $100 so both sides balance.

Question 55

• A company raises $100 worth of Debt‚ at 5% interest and 10% yearly principal repayment‚ to purchase $100 worth of Short-Term Securities with 10% interest attached.
• Walk me through what happens at the end of Year 1‚ after the company has earned interest‚ paid interest‚ and paid back some of the debt principal.

Answer 55

• I/S: Interest Income is $10 ($100 * 10%) and Interest Expense is $5 ($100 * 5%)‚ so Pre-Tax Income increases by $5‚ and NI increases by $3 assuming a 40% tax rate.
• SCF: NI is up by $3. In CFF‚ we repay $10 worth of debt ($100 * 10%)‚ so cash at the bottom is down by $7.
• B/S: Cash on the Assets side is down by $7‚ so the Assets side is down by $7. On the other side‚ Debt is down by $10 due to the repayment and SE (RE) is up by $3 due to the NI‚ so this side is also down by $7 and the B/S balances.

Question 56

• A company raises $100 worth of Debt‚ at 5% interest and 10% yearly principal repayment‚ to purchase $100 worth of Short-Term Securities with 10% interest attached. Now let’s say that at the end of Year 1‚ the company sells the $100 of Short-Term Securities but gets a price of $110 for them instead. It also uses the proceeds to repay the $90 worth of remaining debt.
• Walk me through the statements after ONLY these changes.

Answer 56

• I/S: You record a Gain of $10 ($110 - $100)‚ so Pre-Tax Income is up by $10 and NI is up by $6 with a 40% tax rate.
• SCF: NI is up by $6 but you subtract the Gain of $10‚ so CFO is down by $4. Under CFI‚ you record the $110 as an addition to cash flow‚ so cash is up by $106 so far. Then under‚ CFF‚ you pay off $90 worth of Debt‚ which reduces cash by $90. Overall‚ Cash at the bottom is up by $16.
• B/S: Cash on the Assets side is up by $16 but Short-Term Securities is down by $100‚ so the Assets side is down by $84. On the other side‚ Debt is down by $90 but SE (RE) is up by $6 due to the NI increase‚ so that side is also down by $84 and both sides balance.