Accounting Basics - IB 400

Question 1

Walk me through the 3 financial statements.

Answer 1

The Income Statement shows revenue and expenses, leading to Net Income. The Balance Sheet reflects assets, liabilities, and shareholders’ equity. The Cash Flow Statement shows cash flows from operations, investing, and financing activities, starting with Net Income.

Question 2

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

Answer 2

Income Statement: Revenue, COGS, SG&A, Operating Income, Pre-Tax Income, Net Income.
Balance Sheet: Cash, Accounts Receivable, Inventory, PP&E, Accounts Payable, Shareholders’ Equity.
Cash Flow Statement: Net Income, Depreciation & Amortization, Capital Expenditures, Dividends, Debt Raised/Paid, Stock Issuance/Repurchase.

Question 3

How do the 3 statements link together?

Answer 3

Net Income from the Income Statement becomes the top line of the Cash Flow Statement. Adjust for non-cash expenses, changes in operational balance sheet items, and activities from investing and financing. The resulting change in cash updates the Cash balance on the Balance Sheet, which must balance with Liabilities and Equity.

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 Cash Flow Statement because it gives a true picture of how much cash the company is actually generating – the Income Statement is misleading because it includes non-cash expenses and excludes actual cash expenses such as Capital Expenditures.

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 Income Statement and Balance Sheet because you can create the Cash Flow Statement from both of those (assuming that you have ‘Beginning’ and ‘Ending’ Balance Sheets that correspond to the same period the Income Statement 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, while a Liability will result in less cash or potential cash. Ask what direction cash will move in as a result of this new item.

Question 7

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

Answer 7

Two conditions must be true: 1) It must correspond to the current period. 2) It must be tax-deductible.

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

To reflect that you’ve saved on taxes with the non-cash expense. For example, if your Net Income decreases by $6 due to a $10 expense, adding back the full $10 on the Cash Flow Statement reflects the $4 tax saving.

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 and then Depreciated or Amortized over time.

Question 10

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

Answer 10

Depreciation is tax-deductible, so it reduces the amount of taxes paid, which impacts the cash balance.

Question 11

Where does Depreciation usually appear on the Income Statement?

Answer 11

It could be a separate line item or embedded in Cost of Goods Sold or Operating Expenses. Either way, it reduces Pre-Tax Income.

Question 12

Why is the Income Statement not affected by Inventory purchases?

Answer 12

The expense is recorded on the Income Statement when the goods are sold, not when the Inventory is purchased.

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

Interest payments are tax-deductible and are already accounted for on the Income Statement, whereas debt repayments are not.

Question 14

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

Answer 14

Accounts Payable is mostly for one-time expenses with invoices, while Accrued Expenses is for recurring expenses without invoices.

Question 15

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

Answer 15

When the customer pays upfront for a product/service that hasn’t been delivered yet.

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 Balance Sheet and turns into revenue as the products/services are delivered.

Question 17

Wait a minute… Deferred Revenue reflects cash that we’ve already collected upfront for a product/service we haven’t delivered yet. Why is it a Liability?

Answer 17

Deferred Revenue is a Liability because it implies future expenses to deliver the product/service and may result in additional taxes.

Question 18

What’s the difference between Accounts Receivable and Deferred Revenue?

Answer 18

Accounts Receivable is an Asset representing future cash to be collected, while Deferred Revenue is a Liability representing cash received for undelivered products/services.

Question 19

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

Answer 19

Usually 30-60 days but can vary by industry.

Question 20

How are Prepaid Expenses and Accounts Payable different?

Answer 20

Prepaid Expenses are paid in cash for future products/services and have not yet appeared on the Income Statement, whereas Accounts Payable is for products/services already received but not yet paid for.

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 taxes accrued but not yet paid in cash, similar to Accrued Expenses.

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, Noncontrolling Interest represents the portion you do not own.

Question 23

You see an “Investments in Equity Interests” (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 line represents the portion that you own.

Question 24

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

Answer 24

Yes, typically in cases like leveraged buyouts with dividend recapitalizations or companies with declining retained earnings.

Question 25

What is Working Capital? How is it used?

Answer 25

Working Capital = Current Assets - Current Liabilities. Positive Working Capital means short-term assets can cover short-term liabilities.

Question 26

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

Answer 26

No, because Short-Term Investments are considered investing activities, not operational activities.

Question 27

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

Answer 27

It depends. Companies with high Deferred Revenue or operational efficiencies may have negative Working Capital, which is not necessarily a bad sign.

Question 28

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

Answer 28

Cash-based accounting recognizes transactions when cash changes hands, while accrual accounting recognizes them when they are earned or incurred.

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, revenue is recognized when payment is received. Under accrual accounting, revenue is recognized when earned, even if payment is pending.

Question 30

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

Answer 30

Non-GAAP earnings adjust for non-cash charges like Stock-Based Compensation to provide a better picture of cash profitability.