Accounting - Basic Flashcards
- 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.
This is counter-intuitive. When a liability is written down you record it as a gain on the Income Statement (with an asset write-down, it’s a loss) – so Pre-Tax Income goes up by $100 due to this write-down. Assuming a 40% tax rate, Net Income is up by $60. On the Cash Flow Statement, Net Income is up by $60, but we need to subtract that debt write-down – so Cash Flow from Operations is down by $40, and Net Change in Cash is down by $40. On the Balance Sheet, Cash is down by $40 so Assets are down by $40. On the other side, Debt is down by $100 but Shareholders’ Equity is up by $60 because the Net Income was up by $60 – so Liabilities & Shareholders’ Equity is down by $40 and it balances. If this seems strange to you, you’re not alone – see this Forbes article for more on why writing down debt actually benefits companies accounting-wis
- When would a company collect cash from a customer and not record it as revenue?
Three examples come to mind:
1. Web-based subscription software.
2. Cell phone carriers that sell annual contracts.
3. Magazine publishers that sell subscriptions.
Companies that agree to services in the future often collect cash upfront to ensure stable
revenue – this makes investors happy as well since they can better predict a company’s
performance.
Per the rules of accounting, 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 the Deferred Revenue balance on the Balance Sheet under Liabilities.
Over time, as the services are performed, the Deferred Revenue balance becomes real
revenue on the Income Statement and the Deferred Revenue balance decreases.
- What’s the difference between accounts receivable and deferred revenue?
Accounts receivable has not yet been collected in cash from customers, whereas deferred
revenue has been. Accounts receivable represents how much revenue the company is
waiting on, whereas deferred revenue represents how much it has already collected in
cash but is waiting to record as revenue
- How long does it usually take for a company to collect its accounts receivable
balance?
Generally the accounts receivable days are in the 30-60 day range, though it’s higher for
companies selling high-end items and it might be lower for smaller, lower transaction value companies.
- What’s the difference between cash-based and accrual accounting?
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 a customer has ordered the product) and recognizes expenses when they are
incurred rather than when they are paid out in cash.
Most large companies use accrual accounting because paying with credit cards and lines
of credit is so prevalent these days; very small businesses may use cash-based
accounting to simplify their financial statements
- Let’s say a customer pays for a TV with a credit card. What would this look like
under cash-based vs. accrual accounting?
In 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 show up as both Revenue on the Income Statement
and Cash on the Balance Sheet.
In accrual accounting, it would show up as Revenue right away but instead of appearing
in Cash on the Balance Sheet, it would go into Accounts Receivable at first. Then, once
the cash is actually deposited in the company’s bank account, it would “turn into” Cash.
- How do you decide when to capitalize rather than expense a purchase?
If the asset has a useful life of over 1 year, it is capitalized (put on the Balance Sheet
rather than shown as an expense on the Income Statement). 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 Balance Sheet. Employee salaries and the cost of manufacturing
products (COGS) only cover a short period of operations and therefore show up on the
Income Statement as normal expenses instead.
- Why do companies report both GAAP and non-GAAP (or “Pro Forma”) earnings?
These days, many companies have “non-cash” charges such as Amortization of
Intangibles, Stock-Based Compensation, and Deferred Revenue Write-down in their
Income Statements. As a result, some argue that Income Statements under GAAP no
longer reflect how profitable most companies truly are. Non-GAAP earnings are almost
always higher because these expenses are excluded.
- A company has had positive EBITDA for the past 10 years, but it recently went
bankrupt. How could this happen?
Several possibilities:
1. The company is spending too much on Capital Expenditures – these are not
reflected at all in EBITDA, but it could still be 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 it due to
a “credit crunch” – and it runs out of cash completely when paying back the debt.
4. It has significant one-time charges (from litigation, for example) and those are
high enough to bankrupt the company.
Remember, EBITDA excludes investment in (and depreciation of) long-term assets,
interest and one-time charges – and all of these could end up bankrupting the company.
- Normally Goodwill remains constant on the Balance Sheet – why would it be
impaired and what does Goodwill Impairment mean?
Usually this happens when a company has been acquired and the acquirer re-assesses its
intangible assets (such as customers, brand, and intellectual property) and finds that
they are 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 (see: eBay/Skype).
It can also happen when a company discontinues part of its operations and must impair
the associated goodwill.
- Under what circumstances would Goodwill increase?
Technically Goodwill can increase if the company re-assesses its value and finds that it is
worth more, but that is rare. What usually happens is 1 of 2 scenarios:
- The company gets acquired or bought out and Goodwill changes as a result,
since it’s an accounting “plug” for the purchase price in an acquisition. - The company acquires another company and pays more than what its assets are
worth – this is then reflected in the Goodwill number.
- What’s the difference between LIFO and FIFO? Can you walk me through an
example of how they differ?
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
with 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, $15 each in Q2, $17 each in
Q3, and $20 each in Q4, so that the total is $120 in Q1, $150 in Q2, $170 in Q3, and $200 in
Q4.
You sell 40 of these units throughout the year for $30 each. In both LIFO and FIFO, you
record 40 * $30 or $1,200 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 Cost of Goods Sold, 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 lower Pre-Tax Income and Net Income. The ending inventory value
would be $100 higher under FIFO and $100 lower under FIFO.
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.
- Walk me through the 3 financial statements.
“The 3 major financial statements are the Income Statement, Balance Sheet and Cash
Flow Statement.
The Income Statement gives the company’s revenue and expenses, and goes down to
Net Income, the final line on the statement.
The Balance Sheet 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. 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 and financing activities;
at the end, you see the company’s net change in cash.”
- Can you give examples of major line items on each of the financial statements?
Income Statement: Revenue; Cost of Goods Sold; SG&A (Selling, General &
Administrative Expenses); Operating Income; Pretax Income; Net Income.
Balance Sheet: Cash; Accounts Receivable; Inventory; Plants, Property & Equipment
(PP&E); Accounts Payable; Accrued Expenses; Debt; Shareholders’ Equity.
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.
