Accounting Concepts

Question 1

Walk me through the three financial statements.

Answer 1

The three financial statements are the Income Statement, Cash Flow Statement, and the Balance Sheet.

The Income Statement measures the company’s profitability over a period of time by tracking revenues, expenses, and taxes. The last line item is Net Income.

The Cash Flow Statement tracks the cash flows of a company over a period of time. It begins with Net Income, adjusts for non-cash expenses and changes in operating assets and liabilities (working capital), then shows how the company’s cash balances changed due to Investing or Financing activities. The last line item is the company’s net change in cash.

The Balance Sheet shows a company’s Assets (its resources), Liabilities, and Shareholder’s Equity at a specific point in time. It holds to the equation A = L + SE

Question 2

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

Answer 2

Income Statement:
+ Revenue
- COGS (Cost of Goods Sold)
= Gross Profit
- SG&A (Selling, General, & Expenses)
- Operating Expenses
= Operating Income (EBIT)
Pre-Tax Income
Net Income

Cash Flow Statement:

Cash Flow from Operations:
+ net income
+ depreciation & amortization
- stock-based compensation
+/- changes in working capital (operating assets & liabilities)

Cash Flow from Investing:
- capital expenditures
+ sale of PP&E
+/- sale/purchase of investments

Cash Flow from Financing:
- dividends issued
+/- debt raised/paid off
+/- shares issued/repurchased

Question 3

How do the three statements link together?

Answer 3

Net Income (IS last line) flows to the top line of the CF statement.

In CF statement you add back non-cash charges such as D&A to the Net Income number.

In CF statement net changes in working capital (operating assets and liabilities in the BS) affect Cash Flow from Operations. If operating assets increase, cash flow decreases. If operating liabilities increase, cash flow increases.

Now you take into account investing and financing activities, and the changes to line items like PP&E or Debt on the BS. These affect the CF statement, and result in a net change in cash flow as a final line item in CF.

On the BS, the Cash at the top reflects previous Cash + net change in cash flow from CF final line. IS Net Income flows into BS Retained Earnings.

BS Assets = Liabilities + Shareholder’s Equity.

Question 4

If I wanted to use only one financial statement to review the overall health of a company, which statement would I use and why?

Answer 4

CF because gives picture of how much cash a company is actually generating - the #1 thing you care about when reflecting the overall financial health of a company.

The IS is misleading bc it includes non-cash expenses while excluding cash expenses like CapEx.

Question 5

If I could only look at two financial statements, which would I use?

Answer 5

The IS and the BS because you can create the CF statement from the two of those, if you have the beginning and ending BS for the period that the IS covers.

Question 6

How do you tell what items on the Balance Sheet should be an Asset or a Liability?

Answer 6

Assets result in additional/potential cash in the future. (Accounts Receivable = direct cash increase, Goodwill or PP&E = indirect cash increase)

Liabilities result in less/potentially less cash in the future. (Debt, Accounts Payable = direct cash decrease, Deferred Revenue = indirect cash decrease as you recognize additional taxes in the future as you recognize revenue)

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 expenses to appear on IS:

1) the expense must correspond 100% to the current period
2) the expense must affect the business income available to common shareholders (Net Income to common via tax-deductible, etc)

Items that match these conditions:
- employee compensation
- marketing spending
-depreciation/amortization
- interest expenses

Items that will not be included:
- repaying debt principal (not tax deductible)

Question 8

Why do you add back non-cash expenses from the Income Statement in the Cash Flow Statement?

Answer 8

Because you want to reflect what you’ve saved on taxes with the non-cash expense.

Example: if D&A +10 with a tax rate of 20%, Net Income -8. In the CF, you add back 10 non-cash expenses to Net Income at the top line, and the net change in cash is +2. That +2 represents the tax savings from the non-tax expense.

Question 9

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

Answer 9

If the purchase corresponds with an Asset with a useful life of over 1 year, it is capitalized (BS rather than IS). Then it is depreciated or amortized over a period of years.

Examples: PP&E (factories, equipment), land

Not sure what this means: If you’re paying for a multi-year lease of 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

Because Depreciation is tax-deductible, and therefore changes will cause a change in tax savings.

Question 11

Where does Depreciation usually appear on the Income Statement?

Answer 11

1) embedded into COGS or Operating Expense
2) separate line item

Question 12

Why is the Income Statement not affected by Inventory purchases?

Answer 12

The expense of purchasing Inventory is only recorded on the IS as COGS when the goods associated with it have been manufactured and sold (accrual accounting matching principle).

If Inventory is just sitting in a warehouse, it does not count as COGS.

Question 13

Why DON’T interest payments show up on the Cash Flow Statement, as they’re also a financing activity? Why do Debt repayments show up on the Cash Flow Statement?

Answer 13

Interest payments, because they correspond to the current period and are tax-deductible, are shown on the IS. Because they are a true cash expense and already appeared on the IS, showing them on the CF would be incorrectly double-counting it.

Debt repayments however are a true cash expense that do not appear on the IS, so we need to adjust them on the CF.

Question 14

Why do debt repayments not show up on the Income Statements?

Answer 14

Because debt principal payments are a reduction of a liability, not an expense (which is an operating cost that a company incurs when generating revenue). It therefore only shows up on CF and BS.

Question 15

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

Answer 15

Mechanically, they are both the same – Liabilities on the BS, used when you’ve recorded an IS expense for a product/service you have received but NOT paid for in CASH.

The difference is that Accounts Payable is mostly for one-time expenses with invoices (ex: law firm payment), while Accrued Expenses is for recurring expenses without invoices (employee wages, rent, utilities)

Question 16

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

Answer 16

This happens with Deferred Revenue, when a customer pays upfront for a good or service to be delivered in the future.

Under accrual accounting, you don’t record revenue until 1) control of the good/service is transferred to the customer and 2) you are reasonably sure of payment.

In Deferred Revenue, the control of the good or service hasn’t been transferred to the customer yet, and is therefore not recognized as IS revenue.

Examples: web-based subscription software, magazine subscriptions.

Question 17

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

Answer 17

It goes into Deferred Revenue on the BS under Liabilities.

Over time, as the company’s products/services are delivered to customers, revenues are earned and show on the IS, and the Deferred Revenue balance decreases on the BS.

Question 18

Why is Deferred Revenue considered a Liability on the Balance Sheet?

Answer 18

An Asset results in more cash in the future, while a Liability results in less cash in the future.

Deferred Revenue causes not just a burden on the company to provide future goods and services, but
additional taxes and potentially recognizing additional expenses when we record it as real revenue

Question 19

What is the difference between Accounts Receivable and Deferred Revenue?

Answer 19

Accounts Receivable is when goods/services have been provided to the customer, but the company is awaiting cash payment. It is an Asset because it implied additional future cash.

Deferred Revenue is when a customer pays cash upfront for a good/service to be received in the future. It is a Liability because it implies lower future cash.

There are therefore 2 key differences
1) whether or not cash has been collected from customers
2) whether good/service has been delivered to the customer

Question 20

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

Answer 20

Usually ranging between 30-90 days. It can be higher for companies selling higher-priced items, and lower for companies selling lower-priced items, or cash-only companies.

Question 21

How are Prepaid Expenses and Accounts Payable different?

Answer 21

Prepaid Expenses are expenses that have been pre-paid but have not yet been recognized as expenses on the IS. It is an Asset on the BS.

Accounts Payable occur when a company has recognized an expense on the IS, but has not yet paid cash.

There are therefore 2 key differences:
1) whether cash has been paid or not (Prepaid Expense - cash paid, Accounts Payable - cash not paid)
2) whether good/service has been delivered (Prepaid Expense - not yet delivered, Accounts Payable - delivered)

Question 22

What is the line item “Income Taxes Payable” on the Liabilities side of the Balance Sheet?

Answer 22

Income Taxes Payable are taxes that accrue but are not yet paid in cash.

An example: a company pays income taxes in cash once every 3 months, but produces an IS every month.

Question 23

What is the line item “Non-Controlling Interest” also known as the Minority Interest on the Liabilities side of the Balance Sheet?

Answer 23

A Non-Controlling Interests arise from the accrual accounting rule in which any majority stakes require full consolidation of the parent company and subsidiary company’s financials, even if the stake does not represent complete 100% ownership.

Therefore, on the parent company’s BS you will see a line item for “Non-Controlling Interest” for the less than 50% share of the company the parent company does not own.

Example: You own 70% of a company that is worth $100. On the BS, Liabilities, Non-Controlling Interest = $30

Question 24

What does “Investments in Equity Interests” also known as Associate Companies line item on the Assets side of a Balance Sheet signify?

Answer 24

If you own over 20% but less than 50% of a company, “Investments in Equity Interests” refers to the portion you DO own.

Example: You would 25% of a company worth $100. BS, Assets, Investments in Equity Assets = $25

Question 25

Could you ever have negative Shareholder’s Equity? What does that mean?

Answer 25

Yes.

A few scenarios where this could happen
1) Leveraged Buyouts with dividend recapitalizations = the owner of the company has taken out a large portion of its equity (usually in cash), and this can sometimes turn SE negative.
2) If the company has been losing money consistently, causing a declining Retained Earnings balance as part of Shareholder’s Equity.

Question 26

What is Working Capital and how is it used?

Answer 26

Net Working Capital = Current Assets - Current Liabilities

It’s used to gauge
1) liquidity and 2) short-term financial health = whether a company can pay off its short-term Liabilities with its short-term Assets

More commonly used in finance is
Operating Working Capital = Operating Current Assets (-Cash, -Financial Investments) - Operating Current Liabilities (-Debt)

which excludes items that relate to financing and investing, focusing solely on operations. Changes in Operating Working Capital appear on the CF in CFO, and tells you how these operationally-related balance sheet items change over time.

Question 27

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

Answer 27

No.

Purchases and sales of investments are considered investing activities, not operational activities.

Therefore, Short-Term Investments might technically be included in Net Working Capital, but not Operational Working Capital, which is what we generally mean when we use the term “Working Capital” in finance.

Question 28

What does negative Operating Working Capital Mean? Is it a bad sign?

Answer 28

Negative Operating Working Capital is not always a bad sign.
Some examples of this:

1) companies with subscriptions or longer-term contracts often have negative OWC because of high Deferred Revenue balances – customers have paid upfront for services they have not yet received.

2) retail & restaurant companies (Amazon, Walmart, McDonalds) often have negative OWC because of high Accounts Payable. Customers pay upfront but they wait weeks or months to pay their suppliers – a sign of business efficiency and healthy cash flow.

Bad sign
3) financial trouble or possible bankruptcy, when a company owes money to suppliers (Accounts Payable) but cannot pay with Cash on hand.

Question 29

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

Answer 29

Cash-based accounting recognizes revenue and expenses when cash is received or paid out.

Accrual-based accounting recognizes revenue and expenses when 1) control of goods/services are transferred to the customer and 2) when payment is reasonably assured. Expenses are matched to the period of the corresponding revenue.

Question 30

If a customer pays for a TV with a credit card, how is this reflected with cash-based or accrual-based accounting?

Answer 30

Cash-based accounting:
- revenue is not recognized until the cash is transferred to the company, aka after the customer has paid his credit card bill and the card issuer transfers the money to the company’s bank account.
- At this point it would add to IS Revenue and BS Cash.

Accrual-based accounting:
- revenue is recognized immediately because 1) control of the TV has been transferred to the customer and 2) payment is reasonably certain.
- IS Revenue increased, BS Accounts Receivable increased

Question 31

Why do companies report GAAP/IFRS earnings and non-GAAP “Pro-Forma” earnings?

Answer 31

Many companies have non-cash charges such as Amortization of Intangible Assets, Stock-based Compensation, and Write-Downs on their IS, which negatively affect 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 32

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

Answer 32

There are a few possibilities.

1) the company was spending too much on Capital Expenditures, which are not reflected in EBITDA but are true-cash expenses. CapEx can make a company cash flow negative.
2) the company has a high Interest Expense and can no longer afford its Debt.
3) the company’s Debt all matures at the same time and the company is unable to refinance due to a “credit crunch” (period where banks are reluctant to lend money), and it runs out of cash to pay back its Debt.
4) it has significant one-time charges (ex: litigation) that have been excluded from EBITDA but are high enough to bankrupt the company.

Question 33

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

Answer 33

Usually Goodwill Impairment happens when

1) a company has acquired another company and the acquirer assets what it really got out of the deal (customer relationships, brand name, IP) and finds those Assets are worth less than they originally thought. This happens in acquisitions where the buyer “overpaid” for the seller, and it can result in extremely negative Net Income on the IS.

2) This can also happen when a company discontinues part of its operations, and therefore impairs the associated Goodwill.

Question 34

Does deferred revenue increase or decrease your cashflows?

Answer 34

Deferred Revenue is a Liability on the Balance Sheet. Any increase in a liability is an increase in a source of funding, and therefore increases you cash flows, while a decrease in liability decreases your cash flow.

Question 35

Could you use only two financial statements to find the third? Why/why not?

Answer 35

It depends on what statements you pick.

If you have the IS and “starting” and “ending” BS for that period, you can construct the CF. But there might be some ambiguity (you see net PP&E changes, but not separation of CapEx and D&A)

If you had the IS and CF, you could technically move from the “starting” BS to the “ending” BS.

However, you cannot construct the IS from CF and BS, because there aren’t enough links between the statements.

Question 36

Difference between Goodwill and other Intangible Assets?

Answer 36

Goodwill is the gap between = cookie jar, during good times you put money into Goodwill, bad times you take it out.

Other intangible assets = you can name them, they can amortize.

Question 37

If writing down Liabilities boosts Net Income, why don’t companies do this all the time?

Answer 37

This is like asking, “if declaring bankruptcy helps you relieve your debt obligations, why not rack up debt?”

Because 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 it will eventually be unable to raise debt. The inability to borrow again outweighs the short-term benefit to Net Income.

Question 38

What’s the difference between LIFO and FIFO? Walk me through examples

Answer 38

LIFO stands for “Last-In, First-Out” and FIFO stands for “First-In, First-Out”. They are two different ways of recording the value of Inventory and the Cost of Goods Sold (COGS).

With LIFO, you use the most recent Inventory additions for COGS, while for FIFO you use the oldest Inventory additions for COGS.

Example
Starting inventory balance is $100 (10 units, $10/unit)
Q1: add 10 units, $12/unit = $120
Q2: add 10 units, $15/unit = $150
Q3: add 10 units, $17/unit = $170
Q4: add 10 units, $20/unit = $200

You sell 40 of these units for $30 each.

Revenue = (40)(30) = 1200
LIFO COGS = 200 + 170 + 150 +120 = 640
FIFO COGS = 100 + 120 + 150 + 170 = 540

As prices increase, LIFO will give higher COGS and lower Inventory values. FIFO will give lower COGS and high Inventory values.

Question 39

If a company changes its method of inventory valuation from LIFO to FIFO in an inflationary environment, what is the impact on the three financial statements?

Answer 39

If a company changes its method of inventory valuation from LIFO (last in, first out) to FIFO (first in, first out) in an inflationary environment, it means that the cost of goods sold (COGS) will fall, since goods purchased earlier are being charged to COGS and ending balance of inventory will rise since recently purchased goods will now be reflected in ending inventory. This means that income will rise in the IS, and value of assets will increase in the BS.

Question 40

Name two common ways companies can manage their earnings?

Answer 40

1) Changing accounting practices under GAAP (e.g. switching between S‐L Depreciation and Double Declining Balance; changing between LIFO and FIFO; etc…).

2) “Big bath” (taking negative hits in an already bad year and basically just writing the year off) or “Cookie Jar Accounting” (reducing top‐line revenues in good years and keeping them on reserve for bad years).

Question 41

How would you evaluate the credit worthiness of a company if you were a bank?

Answer 41

A creditor’s measure of an individual’s or company’s ability to meet debt obligations. Lenders will trade off the cost/benefits of a loan according to its risks and the interest charged. But interest rates are not the only method to compensate for risk. Protective covenants are written into loan agreements that allow the lender some controls. These covenants may:

1) Limit the borrower’s ability to weaken their balance sheet voluntarily e.g., by buying back shares, or paying dividends, or borrowing further.
2) Allow for monitoring the debt requiring audits and monthly reports
3) Allow the lender to decide when he can recall the loan based on specific events or when financial ratios like debt/equity, or interest coverage deteriorate.

Credit scoring models also form part of the framework used by banks or lending institutions to grant credit to clients. For corporate and commercial borrowers, these models generally have qualitative and quantitative sections outlining various aspects of the risk including, but not limited to, operating experience, management expertise, asset quality, and leverage and liquidity ratios, respectively.

Question 42

What are common non-cash expenses?

Answer 42

1) Deprecation & Amortization
2) Stock-Based Compensation
3) Unrealized Gains & Losses
4) Asset Write-downs
5) Goodwill Impairments

Question 43

When would a company prefer to use LIFO accounting?

Answer 43

LIFO is when you use the most recent inventory purchases towards COGS when you manufacture products. In the case that inventory prices are rising, using LIFO would mean that your COGS would be larger (than if you used FIFO). A larger COGS results in lower Pre-Tax Income and therefore, lower tax expenses (all else equal). So, using LIFO when inventory costs are rising helps reduce your tax expense.

Question 44

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

Answer 44

Common Mistake = Inventory is part of Working Capital, but changes in Working Capital do not always show up on the Income Statement.

Inventory expense is only recognized when the goods associated with it are sold/revenue is generated from the inventory.

Question 45

Under what circumstances would Goodwill increase?

Answer 45

Technically, this would happen when a company reassesses its Goodwill value and finds Goodwill has increased in value, but this is RARE.

Possible cause 1) the company gets bought out/acquired and the Goodwill changes as a result, as its the “plug” for purchase price in an acquisition.

Possible cause 2) the company acquires another company and pays more than its assets are worth, which is then reflected in Goodwill for the combined outcome.

Question 46

If a company realizes 100 mil in post merger synergies explain to a non-finance person what that means to company valuation

Answer 46

Stealth accounting question… was looking for how line items are effected by cost synergies and how it increases EBITDA and then multiples for overall value

Question 47

If equity raises result in a simple cash inflow, with no expenses on the income statement (unlike debt), why don’t companies use equity issuances more often?

Answer 47

While it’s true that equity issuances don’t create a mandatory interest expense on the IS, or future cash costs, their main downside is that the company is selling part of itself to outsiders.

When a company raises Equity from new investors, the group’s original investors get diluted, meaning
1) they receive less in cash proceeds if the company decides to pay its shareholders
2) if the company ever sells itself, the original owners receive less from the sale

Question 48

Why do you add back Depreciation & Amortization into the Cash Flow Statement?

Answer 48

reason 1) it is a non-cash expense. Adding a non-cash expense on the income statement reduces the net amount of taxes owed on revenue, and adding this back in the CF reflects the cash savings of that tax shield
reason 2) because it allows us to NORMALIZE EARNINGS – different companies use different methods of depreciation, and adding back D&A allows use to more easily compare firms without that added variability. This is especially important in Industrials firms.

Question 49

What’s the difference between Assets, Liabilities, and Shareholder’s Equity line items on the balance sheet?

Answer 49

An Asset provides a future benefit to the company via future cash flow, business growth, or tax savings.

A Liability or Equity line item is something that results in a future obligation for the company, such as cash payment or requirement to deliver a product.

Liabilities are often linked to external parties – lenders, suppliers, or the govt.

Equity line items are linked to the company’s internal operations.

Liabilities and Equity act as funding sources for a company’s resources (Assets), but Equity line items tend not to result in direct cash outflows in the same way as Liabilities.

Question 50

How can you tell whether or not an item should appear on the Cash Flow Statement?

Answer 50

You list an item on CF if

1) it is a non-cash IS line item
Examples: D&A

2) it has NOT appeared on IS and affects a company’s real cash flow
Examples: CFI CapEx, CFF Dividends

Question 51

A company begins offering a 12-month installment plan to customers so they can pay for a $1000 product over a year instead of 100% upfront. How will the company’s cash flow change?

Answer 51

In the short-term, the company’s cash flow would decrease because it is no longer receiving cash upfront.

The long-term impact depends on the results of sales given this change. If sales grow substantially, the increased revenue will offset the company’s longer cash collection process and the long-term cash flow might increase.

Question 52

A company decides to pay its monthly rent by paying for an entire year upfront in cash, as the property owner offered a 10% discount for doing so.

Will this prepayment increase the company’s cash flow?

Answer 52

In the short-term, no, because the company is paying 12*monthly rent in a single month rather than one cash payment per month.

On the IS in month 1, the company will recognize only monthly rent for that month. On the CF the company will record 12*monthly rent under “change in pre-paid expenses” as a cash outflow.

A 10% discount represents over a month of rent, so the company’s cash flow in month 1 will decrease substantially.

Over the entire year, however, this prepayment will improve the company’s cash flows because there will be no additional rent payments after month 1, and the total amount paid in cash will be 10% less by the end of the year.

Question 53

Do you always have to look at the CF to find the full amount of Depreciation?

Answer 53

Yes, because in IS Depreciation is often embedded in COGS or Operating Expenses, not a separate line item.

Question 54

A company collects cash payments from customers for a monthly subscription service one year in advance. Why do companies do this, and what is the cash flow impact?

Answer 54

A company collects cash payments for a monthly service in advance bc it has the market and pricing power to do so. Because of the time value of money, it’s better to collect cash today rather than waiting several months or a year into the future.

This practice always boosts a company’s cash flow. It corresponds to Deferred Revenue (L), which increases cash flow.

When this cash is recognized with revenue, Deferred Revenue (L) declines, and this appears as a negative entry to CF.

Question 55

Why is Accounts Receivable an Asset, while Deferred Revenue is a Liability?

Answer 55

AR provides a future benefit to the company, increased cash flows in the future.

Deferred Revenue is a future obligation for the company, as the company has collected all the cash associated with the sale but is not responsible for delivering the product/service.

These two line items are the opposite of each other via cash/revenue recognition.

Question 56

How are Prepaid Expenses, Accounts Payable, and Accrued Expenses different? Why is Prepaid Expenses an Asset?

Answer 56

Prepaid Expenses have already been paid in cash but haven’t been recognized on the IS. When they occur on the IS they are effectively “non-cash expenses” and reduce a company’s taxes, which makes them an Asset.

Accounts Payable and Accrued Expenses are usually both expenses that are recognized on the IS, but have not yet been paid in cash. AP happens with specific items with invoices (customer orders, legal bills) while AE happens with recurring items without invoices (employee wages, utilities).

*exception = sometimes AP could be items that have not yet appeared on IS, such as purchases on Inventory on credit.

Question 57

Your CEO wants to start paying all employees in Stock-Based Compensation, under the logic it will reduce the company’s taxes and will not “cost it” anything in cash. Is the CFO correct? How does Stock-Based Compensation affect the financial statements?

Answer 57

On a superficial level the CEO is right, but not in reality.

1) the full amount of SBC is not deductible for Cash Tax purposes in most countries, so even if Book Taxes decrease, Cash Taxes likely will not. The eventual tax deduction will take place much further into the future when employees exercise their options or receive their shares.

2) SBC creates additional shares, diluting existing investors and “costing” the company ownership and ability to share in future upside.

Question 58

What are the different ways to fund a company’s operations via external sources, and how do they impact the financial statements?

Answer 58

Debt & Equity

Debt is cheaper, often preferred to use. Company must be able to service its Debt by paying for the interest expense & principal repayments. If it can’t do that it must use equity instead.

Both Equity & Debt issuances show up on the CF statement only, as they boost the company’s Cash balance.

Equity, share count increases immediately after issuances, dilutes existing investors.

Debt, interest payments reflected on IS reducing Net Income & Cash in CF, debt principal repayments in CF and BS.

Question 59

Company sells equipment for market value of $85. The equipment was listed at $100 on your company’s BS, so you record a Loss of $15 on IS, which gets reversed as a non-cash expense on the CF.

Why is this Loss considered a “non-cash expense”?

Answer 59

Loss is a non-cash expense because you haven’t “lost” anything in cash in the current period.

When you sell equipment for $85, you get $85 in cash from the buyer. You didn’t “spend” $15 because you sold the equipment at a reduced price.

The Loss means you spent more than $85 to buy this equipment in a PRIOR PERIOD.

But non-cash adjustments are based on what happens in the CURRENT PERIOD.

Question 60

Your company owns an old factory that’s currently listed at $1000 on its BS. Why might it choose to “write-down” this factory’s value, and what is the impact on the financial statements?

Answer 60

A company might “write-down” an Asset if its value has declined substantially, and its current book value is no longer accurate.

Examples: hurricane, new technology makes factory obsolete

Affect on statements: you record write-down as non-cash expense & reduce Net Income on IS, add back non-cash expense on CF, and reduce BS Asset + reduce SE retained earnings

Write downs are NOT tax-deductible, so you also record negative adjustment under Deferred Taxes on CFS. BS Deferred Tax Asset increases.

Question 61

The CFO of your firm announced plans to purchase “financial investments” (stocks & bonds). Why would she want to do this, and how will this affect the company’s financial statements?

Answer 61

A company might do this if they have excess Cash and cannot think of anything else to do with it.

Can’t: hire more employees, buy more PP&E, acquire other companies, doesn’t want to issue Dividends to investors, repurchase stock, repay Debt.

Initial purchase will show only on CF, under CFI and will reduce cash flow. After interest Income from investments will show on IS and boost pre-tax income, Net Income, and Cash.

Question 62

Could a company have negative Common Shareholder’s Equity on its Balance Sheet? Why/why not?

Answer 62

Yes it could.

CSE components: Net Income + Dividends

1) If Net Income is repeatedly negative, CSE could turn negative as well.
2) If it issued too much in Dividends
3) repurchased too many shares

Question 63

Your firm recently acquired another company for $1000 and created Goodwill of $400 and Other Intangible Assets of $200 on the BS. Why did the company do this?

Answer 63

You create Goodwill and Other Intangible Assets after an acquisition to ensure the BS balances.

In an acquisition, you write down the seller’s CSE and combine its Assets and Liabilities with those of the acquirer.

If you paid exactly what the seller’s CSE was, there’s no problems (the BS balances). However most acquisitions reflect a premium for target companies, which means the BS will go out of balance. You allocate value to Other Intangible Items like trademarks, patents, IP, and customer relationships, and the remainder of the premium goes into Goodwill.

Question 64

How do Goodwill and Other Intangible Assets change over time?

Answer 64

Goodwill does NOT amortize / stays constant unless it is “impaired” (the acquirer decides the company is worth less than it immediately expected and writes down the Goodwill = expense IS, non-cash CF).

Other Intangible Assets amortize over time unless they are indefinite-lived. Amortization shows up on the IS, CF as non-cash expense, and BS Asset decreases until it has amortized completely.

Neither Goodwill Impairment nor the Amortization of Intangibles is deductible for Cash-Tax purposes, so the company’s Cash balance won’t increase. Instead, the Deferred Tax Asset or Deferred Tax Liability will change.

Question 65

A company acquired a machine for $5 million and has since generated $3 million in accumulated depreciation. Today, the PP&E has a fair market value of $20 million. Under GAAP, what is the value of that PP&E on the balance sheet?

Answer 65

The short answer is $2 million. Except for certain liquid financial assets that can be written up to reflect their fair market value (“FMV”), companies must carry the value of assets at their net historical cost.

Question 66

What is the difference between growth and maintenance capex?

Answer 66

Growth Capex:
The discretionary spending of a business to facilitate new growth plans, acquire more customers, and expand geographically. Throughout periods of economic expansion, growth capex tends to increase across most industries (and the reverse during an economic contraction).

Maintenance Capex:
The required expenditures for the business to continue operating in its current state (e.g., repair broken equipment)

Question 67

Which types of intangible assets are amortized?

Answer 67

Intangible assets include customer lists, copyrights, trademarks, and patents, which all have a finite life and are thus amortized over their useful life.

Question 68

What is goodwill and how is it created?

Answer 68

Goodwill represents an intangible asset that captures the excess of the purchase price over the fair market value of an acquired business’s net assets. Suppose an acquirer buys a company for a $500 million purchase price with a fair market value of $450 million. In this hypothetical scenario, goodwill of $50 million would be recognized on the acquirer’s balance sheet.

Question 69

Can companies amortize goodwill?

Answer 69

Under GAAP, public companies are prohibited from amortizing goodwill as it’s assumed to have an indefinite life, similar to land. Instead, goodwill must be tested annually for impairment. However, privately held companies may elect to amortize goodwill and under some circumstances, goodwill can be amortized over 15 years for tax reporting purposes.

Question 70

What is the “going concern” assumption used in accrual accounting?

Answer 70

In accrual accounting, companies are assumed to continue operating into the foreseeable future and remain in existence indefinitely. The assumption has broad valuation implications, given the expectation of continued cash flow generation from the assets belonging to a company, as opposed to being liquidated.

Question 71

Explain the reasoning behind the principle of conservatism in accrual accounting.

Answer 71

The conservatism principle requires thorough verification and use of caution by accountants when preparing financial statements, which leads to a downward measurement bias in their estimates.

Central to accounting conservatism is the belief that it’s better to understate revenue or the value of assets than to overstate it (and the reverse for expenses and liabilities). As a result, the risk of a company’s revenue or asset values being overstated and expenses or liabilities being understated is minimized.

Question 72

Why are most assets recorded at their historical cost under accrual accounting?

Answer 72

The historical cost principle states that an asset’s value on the balance sheet must reflect the initial purchase price, not the current market value. This guideline represents the most consistent measurement method since there’s no need for constant revaluations and markups, thereby reducing market volatility.

Question 73

Why are the values of a company’s intangible assets not reflected on its balance sheet?

Answer 73

The objectivity principle of accrual accounting states that only verifiable, unbiased data can be used in financial filings, as opposed to subjective measures. For this reason, internally developed intangible assets such as branding, trademarks, and intellectual property will have no value recorded on the balance sheet because they cannot be accurately quantified and recorded.

Companies are not permitted to assign values to these intangible assets unless the value is readily observable in the market via acquisition. Since there’s a confirmable purchase price, a portion of the excess amount paid can be allocated towards the rights of owning the intangible assets and recorded on the closing balance sheet.

Question 74

Why are increases in accounts receivable a cash reduction on the cash flow statement?

Answer 74

Since the cash flow statement begins with net income and net income captures all of a company’s revenue (not just cash revenue), an increase in accounts receivable means that more customers paid on credit during the period. Thus, a downward adjustment must be made to net income to arrive at the ending cash balance. Although the revenue has been earned under accrual accounting standards, the customers have yet to make the due cash payments and this amount will be sitting as receivables on the balance sheet.

Question 75

Why is deferred revenue classified as a liability while accounts receivable is an asset?

Answer 75

Deferred Revenue:For deferred revenue, the company received payments upfront and has unfulfilled obligations to the customers that paid in advance, hence its classification as a liability.

Accounts Receivable:A/R is an asset because the company has already delivered the goods/services and all that remains is the collection of payments from the customers that paid on credit.

Question 76

Why are increases in accounts payable shown as an increase in cash flow?

Answer 76

An increase in accounts payable would mean the company has been delaying payments to its suppliers or vendors, and the cash is currently still in the company’s possession. The due payments will eventually be made, but the cash belongs to the company for the time being and is not restricted from being used. Thus, an increase in accounts payable is reflected as an inflow of cash on the cash flow statement.

Question 77

What do the phrases “above the line” and “below the line” mean?

Answer 77

The expression “the line” is in reference to operating income, which represents the point that divides normal, ongoing business operations from non-operational line items.

If a profitability metric is “above the line,” it reflects a company’s operational performance before non-operational items such as interest and taxes. Example: EBITDA

In contrast, profitability metrics “below the line” have adjusted operating income for non-operating income and expenses, which are items classified as discretionary and unrelated to the core operations of a business.
Example: Net Income

Question 78

Is EBITDA a good proxy for operating cash flow?

Answer 78

While EBITDA does add back D&A, typically the largest non-cash expense, it doesn’t capture the full cash impact of capital expenditures (“capex”) or working capital changes during the period.

Extra info:
EBITDA also doesn’t adjust for stock-based compensation, although an increasingly used “adjusted EBITDA” metric does add-back SBC.

These non-cash and any non- recurring adjustments must be properly accounted for to assess a company’s past operational performance and to accurately forecast its future cash flows

Question 79

Is negative working capital a bad signal about a company’s health?

Answer 79

Further context would be required, as negative working capital can be positive or negative. For instance, negative working capital can result from being efficient at collecting revenue, quick inventory turnover, and delaying payments to suppliers while efficiently investing excess cash into high-yield investments.

However, the opposite could be true, and negative working capital could signify impending liquidity issues. Imagine a company that has mismanaged its cash and faces a high accounts payable balance coming due soon, with a low inventory balance that desperately needs replenishing and low levels of AR. This company would need to find external financing as early as possible to stay afloat.

Question 80

What does change in net working capital tell you about a company’s cash flows?

Answer 80

The change in net working capital is important because it gives you a sense of how much a company’s cash flows will deviate from its accrual-based net income.

If a company’s NWC has increased year-over-year, its operating assets have grown and/or its operating liabilities have shrunk from the prior year. Since an increase in an operating asset is a cash outflow, it should be intuitive why an increase in NWC means less cash flow for a company (and vice versa).

Question 81

How would you forecast capex and D&A when creating a financial model?

Answer 81

In the simplest approach, D&A can be projected as either a percentage of revenue or capital expenditures, while capex is forecasted as a percentage of revenue. Re-investments such as capex directly correlate with revenue growth, thus historical trends, management guidance, and industry norms should be closely followed.

Alternatively, a depreciation waterfall schedule can be put together, which would require more data from the company to track the PP&E currently in-use and the remaining useful life of each. In addition, management plans for future capex spending and the approximate useful life assumptions for each purchase will be necessary.

As a result, depreciation from old and new capex will be separately shown. For projecting amortization, useful life assumptions would also be required, which can often be found in a separate footnote in a company’s financial reports.

Question 82

Why might the current ratio be misleading?

Answer 82

Current Ratio = Current Assets / Current Liabilities

1) The cash balance used includes the minimum cash amount required for working capital needs - meaning operations could not continue if cash were to dip below this level.

2) Similarly, the cash balance may contain restricted cash, which is not freely available for use by the business and is instead held for a specific purpose.

3) Short-term investments that cannot be liquidated in the markets easily could have been included (i.e., low liquidity, cannot sell without a substantial discount).

4) Accounts receivable could include “bad A/R”, but management refuses to recognize it as such.

Question 83

Is it bad if a company has negative retained earnings?

Answer 83

Not necessarily. Retained earnings can turn negative if the company has generated more accounting losses than profits. For example, this is often the case for startups and early-stage companies investing heavily to support future growth (e.g., high capex, sales & marketing expenses, R&D spend).

Another component of retained earnings is the payout of dividends and share repurchases, contributing to lower or even negative retained earnings. In these scenarios, the negative retained earnings mean the company has returned more capital to shareholders than taken in.

Question 84

How can a profitable firm go bankrupt?

Answer 84

To be profitable, a company must generate revenues that exceed expenses.

However, if the company is ineffective at collecting cash from customers and allows its receivables to balloon, or if it cannot get favorable terms from suppliers and must pay cash for all inventories and supplies, the company can suffer from liquidity problems due to the timing mismatch of cash inflows and outflows.

Profitable companies with these types of working capital issues can usually secure financing, but if financing suddenly becomes unavailable (e.g., 2008 credit crisis), the company could be forced to declare bankruptcy.

Alternatively, a profitable company that took on far too much debt in its capital structure and could not service the interest payments may also default on its debt obligations.

Question 85

Does a company truly not incur any costs by paying employees through stock-based compensation rather than cash?

Answer 85

Stock-based compensation is a non-cash expense that reduces a company’s taxable income and is added-back on the cash flow statement.

However, SBC incurs an actual cost to the issuer by creating additional shares for existing equity owners. The issuing company, due to the dilutive impact of the new shares, becomes less valuable on a per-share basis to existing shareholders.

Question 86

What is the difference between a write-down and a write-off?

Answer 86

Write-Downs:
In a write-down, an adjustment is made to an asset such as inventory or PP&E that has become impaired. The asset’s fair market value (FMV) has fallen below its book value; hence, its classification as an impaired asset. Based on the write-down amount deemed appropriate, the value of the asset is decreased to reflect its true value on the balance sheet. Examples of asset write-downs would include damages caused by minor fires, accidents, or sudden value deterioration from lower demand.

Write-Offs:
Unlike a write-down in which the asset retains some value, a write-off reduces an asset’s value to zero, meaning the asset has been determined to hold no current or future value (and should therefore be removed from the balance sheet). Examples include uncollectible AR, “bad debt,” and stolen inventory.

Question 87

For long-term projects, what are the two methods for revenue recognition

Answer 87

Percentage of Completion Method:
In the percentage of completion method, revenue is recognized based on the percentage of work completed during the period. This method is used far more common since it’s in a company’s best interest to record partial revenue once earned. Two conditions must be met to use this method: the collection of payment must be reasonably assured, and the total project costs with the estimated completion date are required to be provided.

Completed Contract Method:
The completed contract method recognizes revenue once the entire project has been completed. This method is rarely used in the US, as it would result in a company under- reporting revenue that has been earned under the accrual-based system.

Question 88

If a company has continuously incurred goodwill impairment charges, what do you take away from seeing this in their financials?

Answer 88

Goodwill on the balance sheet remains unchanged unless it’s impaired, meaning the purchaser has determined that the acquired assets are worth less than initially thought. While goodwill impairment can be attributed to unforeseeable circumstances, impairments as a common occurrence may raise concerns regarding the management team’s history of overpaying for assets or their inability to integrate new acquisitions.

Question 89

What is restricted cash and could you give me an example?

Answer 89

Restricted cash is cash reserved for a specific purpose and not available for the company to use. On the balance sheet, the restricted cash will be listed separated from the unrestricted cash, and there’ll be an accompanying disclosure providing the reasoning why this cash cannot be used. An example of restricted cash would be if a company signed an agreement to receive a line of credit, but the lender has required the borrower to maintain 10% of the total loan amount at all times (i.e., “bank loan requirement”). As long as the line of credit is active, the 10% minimum must be preserved to avoid breaching the lending terms. The company may have a separate bank account to hold the funds, or the lender may have required the amount to be placed in escrow to ensure compliance.

Question 90

What is PIK interest?

Answer 90

PIK stands for “Paid-in-Kind.” PIK interest expense is interest charged by a lender that accrues towards the ending debt balance as opposed to being paid in cash in the current period. While opting for PIK may conserve cash for the time being from deferring interest payments to a later date, the debt principal due at maturity increases each year, as well as the accrued interest payment amount.

Question 91

If a company has incurred $100 in PIK interest, how would the three-statements be impacted?

Answer 91

IS:
On the income statement, interest expense will increase by $100, which causes EBIT to decrease by $100. Assuming a 30% tax rate, net income will decrease by $70.

CFS:
On the cash flow statement, net income will be down by $70, but the $100 non-cash PIK interest will be added back. The ending cash balance will increase by $30.

BS:
On the assets side of the balance sheet, cash will be up $30. Then on the liabilities side, the debt balance will be up $100 (since the PIK accrues to the debt’s ending balance), and net income is down $70. Therefore, both sides are up by $30, and the balance sheet balances.