Accounting Basics Theory

Question 1

Walk me through the 3 financial statements.

Answer 1

The 3 major financial statements are the Income Statement, Balance Sheet, and Cash Flow Statement. The Income Statement shows revenue and expenses over a period of time, down to Net Income. The Balance Sheet shows Assets, Liabilities, and Shareholders’ Equity at a specific point in time. The Cash Flow Statement adjusts Net Income for non-cash items and changes in operating assets and liabilities and then shows cash spent or received from investing and financing activities.

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, Accrued Expenses, Debt, Shareholders’ Equity.
Cash Flow Statement: Cash Flow from Operations, Cash Flow from Investing, Cash Flow from Financing.

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. Adjustments for non-cash items and changes in working capital appear, leading to Cash Flow from Operations. Changes in PP&E and debt from the Balance Sheet are reflected in investing and financing activities, respectively. Net change in cash flows into the next period’s Balance Sheet as Cash. Net Income also affects Shareholders’ 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 shows the actual cash the company generates, reflecting its financial health more accurately than the Income Statement, which includes non-cash items.

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 use the Income Statement and the Balance Sheet because you can create the Cash Flow Statement from them if you have beginning and ending Balance Sheets for the same period.

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 results in additional cash or potential cash in the future, while a Liability results in less cash or potential cash in the future. Think about the direction of cash flow associated with the 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: it must correspond to the current period, and it must be tax-deductible.

Question 8

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

Answer 8

Depreciation reduces taxable income, lowering taxes paid, which increases cash balance.

Question 9

What happens when Accrued Expenses increase by $10?

Answer 9

Net Income decreases by $6 (40% tax rate), and Cash Flow from Operations increases by $10 due to the non-cash nature of the expense. Cash increases by $4. On the Balance Sheet, Cash is up by $4, Liabilities are up by $10, and Retained Earnings are down by $6, balancing the sheet.

Question 10

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 10

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 Net Income decreases by $6 as a result… but then you add back the entire non-cash expense of $10 on the CFS 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 our taxes or cash balance.”

Question 11

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

Answer 11

If the purchase corresponds to an Asset with 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 “last” for the current period and therefore show up on the Income Statement 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 12

Where does Depreciation usually appear on the Income Statement?

Answer 12

It could be in a separate line item, or it could be embedded in Cost of Goods Sold or Operating Expenses – each company does it differently. Note that the end result for accounting questions is the same: Depreciation always reduces Pre-Tax Income.

Question 13

Why is the Income Statement not affected by Inventory purchases?

Answer 13

The expense of purchasing Inventory is only recorded on the Income Statement 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 14

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 14

The difference is that interest payments correspond to the current period and are tax-deductible, so they have already appeared on the Income Statement. Since they are a true cash expense and already appeared on the IS, showing them on the CFS would be double-counting them and would be incorrect.
Debt repayments are a true cash expense but they do not appear on the IS, so we need to adjust for them on the CFS.
If something is a true cash expense and it has already appeared on the IS, it will never appear on the CFS unless we are re-classifying it – because you have already factored in its cash impact.

Question 15

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

Answer 15

Mechanically, they are the same: they’re Liabilities on the Balance Sheet used when you’ve recorded an Income Statement 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 (see the model).
The difference is that Accounts Payable 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, rent, and utilities.

Question 16

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

Answer 16

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. Cases where you see this:
1. Web-based subscription software.
2. Cell phone carriers that sell annual contracts.
3. Magazine publishers that sell subscriptions.

Question 17

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

Answer 17

It goes into the Deferred Revenue balance on the Balance Sheet under Liabilities.
Over time, as the services or products are delivered, the Deferred Revenue balance turns into real revenue on the Income Statement and the Deferred Revenue balance decreases.

Question 18

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

Answer 18

There are 2 main differences:
1. Accounts Receivable has not yet been collected in cash from customers, whereas Deferred Revenue has been.
2. Accounts Receivable is for a product/service 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.
Accounts Receivable is an Asset because it implies additional future cash whereas Deferred Revenue is a Liability because 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 (PE) and Accounts Payable (AP) different?

Answer 20

It’s similar to the difference between Accounts Receivable and Deferred Revenue above:
1. Prepaid Expenses have already been paid out in cash, but haven’t yet shown up on the Income Statement, whereas Accounts Payable haven’t been paid out in cash but have shown up on the IS.
2. PE is for product/services that have not yet been delivered to the company, whereas AP 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 Income Statements 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 Balance Sheet to represent the 30% 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 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 Balance Sheet to represent the 25% that you own.

Question 24

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

Answer 24

Yes. It is common in 2 scenarios:
1. Leveraged Buyouts with 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 a declining Retained Earnings balance, which is a portion of Shareholders’ Equity.

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.

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 defined, but left out of “Operating Working Capital.”
But the truth is that no one lists Short-Term Investments in this section because 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” because that’s a more accurate way to describe the concept of operationally-related Balance Sheet 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 because of high Deferred Revenue balances.
2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald’s often have negative Working Capital because customers pay upfront, but they wait weeks or months to pay their suppliers – this is a sign of business efficiency and means that they always have 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 because 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 Income Statement (and Pre-Tax Income, Net Income, etc.) and Cash on the Balance Sheet.
Under 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 move into the Cash line item and Accounts Receivable would go down.

Question 30

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

Answer 30

There are several possibilities:
1. The company is spending too much on Capital Expenditures – 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 it 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.

Question 31

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

Answer 31

Usually this happens when a company buys another one and the acquirer re-assesses 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 Income Statement.