Accounting Basics

Question 1

Walk me through the 3 financial statements.

Answer 1

Income Statement, Balance Sheet, Statement of Cash Flow
1. Income Statement: shows the revenue and expense; goes down to net income
2. Balance Sheet: shows assets, liabilities, and shareholders’ equity. Asset = liabilities + shareholders’ equity
3. Cash Flow Statement:
- begins with Net Income;
- adjusts for non-cash expenses and working capital change (difference between net assets and net liabilities);
- then lists cash flow from investing and financing activities;
- at the end, you’ll see the company’s net change in cash

Question 2

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

Answer 2

1. Income statement:
   - Revenue
   - COGS
   - SG&A
   - Operating Income
   - Pre-tax Income
   - Net Income
2. Balance Sheet:
   - Cash
   - Account Receivable
   - Inventory
   - PP&E
   - Account Payable
   - Unearned Revenue
   - Debt
   - Common Stock
   - Retained earnings
3. Cash flow
   - Net Income
   - Depreciation & Amortization
   - Stock-Based Compensation
   - Changes in Operating Assets and Liabilities
   - Cashflow from operations
   - CAPEX
   - Cashflow from investing
   - Sale/purchase of securities
   - Dividends
   - Bond Issued
   - Cashflow from financing

Question 3

How do the 3 statements link together?

Answer 3

Net Income from I/S –> the shareholder equity in B/S –> top line on the cash flow statement

Question 4

If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company – which statement would I use and why?

Answer 4

Cash flow statement.
- a true picture of how the company’s financial health
- independent from all the non-cash expenses

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

I/S and B/S because you can calculate the Cash Flow Statement from the two.

Question 6

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

Answer 6

• I/S: operating income decline by $10; 40% tax rate –> decrease overall net income by 6 (4%付给 tax了)
• Cashflow statement: net income goes down by 6, but $10 depreciation is a non-cash expense ==> cashflow from operations increase by 4
• B/S: PP&E goes down by $10 due to depreciation; cash increases by $4 from the changes in cash flow

Overall, the asset side is down by 6, and the net income from the right is also down by 6, so the b/s balances.

Question 7

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

Answer 7

Although it’s a non-cash expense, it is tax deductible. Since tax is a cash expense, depreciation affects cash by decreasing the amount of cash needed to pay.

Question 8

Where does Depreciation usually show up on the Income Statement?

Answer 8

Depreciation expense

Question 8

What happens when Accrued Compensation goes up by $10?

Answer 8

First confirm that the accrued compensation is recognized as expense
1. I/S
- Pre-tax income falls by $10; Net Income falls by $6
2. Cash Flow Statement
- Net Income falls by $6
- Increase CFO by $10
- Total increase by $4
3. B/S
- Cash is increased by $4
- Accrued Compensation is a liability; liability increase by $10
- Net Income falls by $6

Question 9

What happens when inventory goes up by $10

Answer 9

1. I/S
   - No change
2. Statement of cashflow
   - Decrease by $10
3. B/S
   - Inventory is up by 10 on the asset side
   - cash is down by 10

Question 10

Why is the Income Statement not affected by changes in Inventory?

Answer 10

It is not recognized as an expense because it is not sold yet

Question 11

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?

Answer 11

1. I/S:
   - no change
2. Cash flow:
   - the $100 investment would decrease the cash flow by $100
   - the new $100 debt would increase the cash flow
   - number stays the same
3. B/S:
   - $100 addition for the asset in PPE
   - $100 addition of debt would show up as liabilities

Question 12

Now let’s go out 1 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? Assume tax rate is 40%

Answer 12

1. I/S
   - depreciation ==> operation income decrease $10
   - interest rate of 10% ==> decrease pre-tax income by $20 in total
   - tax rate = 10%; 20(1-40%) = 12; decrease net income by $12
2. Cash flow
   - net income at the top is decreased by $12
   - add depreciation by $10
   - CFI decreased by 2
3. B/S
   - cash is down by $2 (A)
   - PPE is down by $10 (A)
   - net income is down by $12 (L)

Question 13

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.
Assumes 40% tax rate.

Answer 13

The value of the factory is $80 (due to depreciation)
1. I/S
- Write down expense $80
- Net income decrease by 80(1-0.4) = 800.6=48
2. Cash flow statement
- Net income down by $48
- Write down is a non-cash expense ==> CFO add back $80
- CFF: $100 charge for loans ==> decrease $100
- Total decrease by $68
3. B/S
- Cash is down by $48 (A)
- PPE down by $80 (A)
- Debt is down $100 (L)
- Net Income is down $48

Question 14

Now let’s look at a different scenario and assume Apple is ordering $10 of additional iPod 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 14

1. I/S
   - No change
2. Cash flow statement
   - inventory is up by $10, so decrease CFO by $10
3. B/S
   - Inventory increases by $10
   - Cash decreases by $10

Question 15

Now let’s say they sell the iPods for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario.
Assume a 40% tax rate.

Answer 15

1. I/S
   - Revenue increase by $20
   - COGS decrease by $10
   - Net Income increase by $6
2. Cash Flow Statement
   - Net Income is up by $6
   - Inventory decreased by $10; add $10
   - CFI increases by $16
3. B/S
   - Cash is up by $16 (A)
   - Inventory is down by $10 (A)
   - Net income is up by $6 (S/E)

Question 16

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

Answer 16

Yes, it’s common in these 2 scenarios
1. Leveraged Buyouts (LBO) with dividend recapitalizations
2. Losing money consistently ==> negative retained earning

Question 17

What is working capital? How is it used?

Answer 17

working capital = current assets - current liabilities

Question 18

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

Answer 18

when the current assets are less than the current liabilities. Not necessarily a bad sign. Depends:
1. Companies with long contracts/subscriptions tend to have negative working capital because of the high Deferred Revenue balances.
2. For retail and restaurants companies, negative working capital would mean that they receive upfront payment from customers, in which they could be used to pay off liabilities rather than keeping a large cash balance on-hands.
3. In other cases, working capitals could mean financial troubles. for example, when customers don’t pay quickly and upfront and the company is carrying a high debt balance
Low capital: quicker cash collections from customers; higher inventory turns; longer supplier terms

Question 19

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.

Answer 19

1. I/S
   - pre-tax income down by $100
   - Assume 40% tax rate; down by $60
   - Net Income down by $60
2. Cash flow
   - Net Income down by $60
   - Add back $100 write down
   - Cash flow increase $40
3. B/S
   - Cash increase $40
   - Assets decrease $100
   - Net Income down by $60

Question 20

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

Answer 20

Bail out: 救助
What types “bailout” it is? Equity or Debt? Most cases, it’s a equity investment from the government
1. I/S: doesn’t change (not a revenue nor expense)
2. Cash flow: CFI goes up by $100
3. B/S:
- Cash up by $100
- Shareholders’ Equity up by $100

Question 21

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 21

• Liability write-down: gain (不用还了)
• Assets write-down: loss (收不了了)
  1. I/S
• Pre-tax income up by $100
• Assume 40% tax rate; net income up by $60
  2. Cash flow
• Net income up by $60
• CFO is down by $100 ( 减non-operating gain)
• Total cash is down by $40
  3. B/S
• Cash is down by $40
• Debt is down by $100
• Net income is up by $60

Question 22

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

Answer 22

Unearned Revenue
1. Web-based subscription software.
2. Magazine publishers that sell subscriptions.
3. Cell phone carriers that sell annual contracts.

Question 23

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

Answer 23

Recorded as U/R, which is a liability

Question 24

What’s the difference between accounts receivable and deferred revenue?

Answer 24

1. A/R: when you delivered the good but didn’t collect cash
2. Deferred revenue: when you received cash but haven’t delivered the good/service

Question 25

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

Answer 25

• generally between 30-60 days
• more high-end products ==> longer the time

Question 26

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

Answer 26

1. Accrual: only recognize expenses and revenues when the good or service is delivered
2. Cash-based: recognize expenses and revenues when cash is received

Question 27

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 27

1. Cash-based: company would not recognize the revenue until the payment is authorized.
2. Accrual accounting: show up as revenue right away, but would credit account receivable; once collected cash; debt cash and credit a/c receivable

Question 28

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

Answer 28

• capitalize an expense: recording a cost as an asset on the b/s rather than as an expense on the i/s
• If the asset has a useful life of over 1 year, it is capitalized

Question 29

Why do companies report both GAAP and non-GAAP (or “Pro Forma”) earnings?

Answer 29

• Non-GAAP doesn’t include non-cash expenses (such as amortization and depreciation), while GAAP do

Question 30

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

Answer 30

1. Spending too much on CAPEX
2. High interest expense and can no longer afford its debt
3. One-time charges (from litigation)

Question 31

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

Answer 31

1. When a company is acquired, and the acquirer re-assesses the non-tangible assets (customer loyalty, brand, patent) and finds that they are worth less than they originally thought
2. When a company discontinues part of its oepration ==> must impair the associated goodwill

Question 32

Under what circumstances would Goodwill increase?

Answer 32

The acquisition price is higher than the market value of the company’s net asset; then goodwill acts as a plug that fills in the gap