Accounting Concepts

Question 1

Walk me through the income statement

Answer 1

a. Income statement -> profitability over a specified period

Structure:
Revenue, less
COGS
= Gross Profit, less

SellingG&A
R&D
D &A,
= Operating Income/EBIT, less

Interest expense,
= Pre-tax income, less

Tax,
= Net Income

Question 2

Walk me through the balance sheet

Answer 2

a. Balance sheet -> assets, liabilities and equity as a specific point in time.

Accounting equation: Assets = liabilities +equity

Assets

Current assets: consumed within a year

Cash, cash equivalents
Accounts receivables
Inventory
Pre-paid expenses

Non-current assets: consumed 1year+
PPE
Intangible assets
Goodwill

Liabilities: Obligations owed to other parties and represent sources of capital to a company

Current liabilities - owed within 12 months:
Accounts payable
Accrued expenses
Short term Det

Non-current liabilities - owed 12 months +:
Deferred revenue
Deferred tax
Long term debt
Lease obligations

Shareholders’ Equity - claims of owner’s to the assets of the business

Common stock

Paid-in capital: money a company receives in exchange for issuing shares: par value + any amount in excess of that

Preferred stock: gives a higher claim to dividend to dividends or asset distribution (hybrid)

Treasury stock: previously issued shares, repurchased in a buyback, not traded

Retained earnings: cumulative earnings less dividend payments

Other comprehensive income: foreign currency translation adjustments

Question 3

Definition and examples of current assets

Answer 3

Current assets: consumed within a year

Cash, cash equivalents
Accounts receivables
Inventory
Pre-paid expenses

Question 4

Definition and examples of non-current assets

Answer 4

Non-current assets: consumed 1year+
PPE
Intangible assets
Goodwill

Question 5

Definition and examples of current liabilities

Answer 5

Current liabilities - owed within 12 months:
Accounts payable
Accrued expenses
Short term Det

Question 6

Definition and examples of non-current liabilities

Answer 6

Non-current liabilities - owed 12 months +:
Deferred revenue
Deferred tax
Long term debt
Lease obligations

Question 7

Paid-in capital:

Answer 7

Money a company receives in exchange for issuing shares: par value + any amount in excess of that

Question 8

Preferred stock:

Answer 8

Gives a higher claim to dividends or asset distribution (hybrid), such as a fixed divident each year or quarter (similar to a debt instrument)

Question 9

Treasury stock:

Answer 9

Previously issued shares, repurchased in a buyback, not traded

Question 10

Retained earnings:

Answer 10

Cumulative earnings less dividend payments

Question 11

Other comprehensive income:

Answer 11

Foreign currency translation adjustments

Question 12

Walk me through the cash flow statement

Answer 12

Most common method is indirect, whereby cash flow broken out into:

Cash flow from operations

Start with net income

Add back D&A + stock based compensation

Adjustments in working capital: Inventories + accounts receivables (cash outflows) - accounts payables (cash inflows)

Cash flow from investing
Capital expenditures
Business acquisitions, divestments

Cash flow from financing
Net cash from fundraising: equity or debt

Cash outflows from dividend payments

Question 13

How are the three financial statements linked?

Answer 13

Income Statement to Cash Flow Statement: Bottom line of the income statement is the first line in cash flow from operations.

Income Statement to Balance Sheet:

Retained earnings: Net income - dividend payments is added to retained earnings in the BS

Interest expense: calculated on beginning and end cash balance of balance sheet

PP&E on the balance sheet is reduced by depreciation expense in the income statement

Cash Flow Statement to Balance Sheet:

Operations: Tracks changes in working capital from balance sheet: current assets + liabilities

Investing: Tracks capital expenditures from balance sheet: purchases of PPE

Financing: Tracks issuances of debt, equity, share buybacks from the balance sheet

Ending cash balance flows through to cash balance in the balance sheet

Question 14

Would you pick the income statement or cash flow statement to analyse a company?

Answer 14

Cash flow statement reflects the true liquidity of a company without the effect of accrual accounting conventions

Equity or investors look at cash flows

Gloss: if assessing profitability, income statement more useful, can value a company based on earnings multiples.

Question 15

What are some discretionary management decisions that could inflate earnings?

Answer 15

Depreciation policies: extending the useful life of an asset, lowers depreciation charge on the income statement, increases net income.

More aggressive revenue recognition policies

Capitalising costs instead of expensing them, reduces expenses and increases net income
Deferral of CAPEX or R&D to the next period to show more profitability and cash flow in the current period.

Question 16

What is the difference between COGS and Operating Expenses?

Answer 16

COGS are the direct costs associated with the production of a good or service to generate revenue. Direct material and labour costs.

Operating expenses are indirect costs associated with the above, such as travel expenses, advertising and marketing, rent and utilities.

Question 17

When do you capitalize vs. expense items under accrual accounting?

Answer 17

Main factor is its expected useful life.

Expenditures on items that are expected to benefit the firm for more than one year (e.g. fixed assets and intangible assets) are capitalised and expensed over time.

When benefits received to a firm are short-term, expensed in the current period, (e.g. purchases of inventory and wage expenses

Question 18

If depreciation is a non-cash expense, how does it affect net income?

Answer 18

Depreciation is an expense and so lowers net income: Operating profit or EBIT is calculated after subtracting depreciation.

In addition, depreciation is tax deductible and so lowers the tax burden by the amount of depreciation x the tax rate.

Question 19

Do companies prefer straight line or accelerated depreciation?

Answer 19

Companies prefer straight line depreciation because accelerated depreciation leads to lower net income in the earlier years.

SL depreciation therefore results in higher net income and higher earnings per share in the earlier years

Companies typically prefer this as they focus on near term earnings results.

Question 20

What is the relationship between depreciation and the salvage value assumption?

Answer 20

Relationship: the difference between the cost of the asset and estimated residual value of an asset at the end of its useful life (or the salvage value), is the total depreciable amount.

Depreciable amount divided by the assumed useful life = annual depreciation charge.

So, as the assumed salvage value increases, the depreciation charge decreases (and vice versa)

If the salvage value is assumed to be zero, the depreciation charge would be higher and this maximises the tax benefit.

Question 21

Do companies depreciate land?

Answer 21

No. Land is assumed to have an indefinite useful life.

Question 22

How does $10 of depreciation flow through the financial statements? Assume T=30%

Answer 22

Income Statement:
Reduces EBIT by $10
Reduces Net Income by (1-T)10= $7
Reduces tax burden by T10= $3

Cash Flow Statement:
First line Cash Flow from Operations is Net Income, reduced by $7
Depreciation is a non-cash item that is added back, add $10
Net change in cash +$3

Balance Sheet:
L&E: Retained Earnings decreases by $7 (taken through from Net Income)
A: Cash is +$3, but PP&E -$10, so -$7 all balances

Question 23

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 23

GAAP: $2 million. Companies must carry the value of assets at their historical cost, less accumulated depreciation

Question 24

What is the difference between growth and maintenance capex?

Answer 24

Growth: Discretionary spending of a business invested in assets that will deliver benefits for the business over the long term. Capitalised into the balance sheet. E.g. Purchase of PPE.

Maintenance: Spending to maintain the current operating capacity of a business. If not extending the useful life of an asset, expensed in income statement. E.g. Routine repairs and maintenance

Question 25

What type of assets are amortised?

Answer 25

Intangible assets: copyrights, trademarks, softwares, customer lists. Amortised over their useful life.

Question 26

What is goodwill and how is it created?

Answer 26

Goodwill: Excess of the purchase price paid over the fair value of the net assets (assets-liabilities) acquired (not the book value).

Goodwill is created as a plug for the balance sheet to remain balancce

Question 27

What types of assets are amortized?

Answer 27

• Amortization based on the same accounting concept as depreciation (e.g., you expense the cost of the asset over a period of time), but it applies to intangible assets.
  
  • E.g., patents, copyrights, trademarks, software, customer lists.
    These have a finite life and are amortized over their useful life.

Question 28

What is goodwill and how is it created? (Walk through a simple example)

Answer 28

Goodwill: Excess of the purchase price paid over the fair value of the net assets (assets-liabilities) acquired (not the book value).

Goodwill is created as a plug for the balance sheet to remain balanced:

Question 29

Is goodwill amortized?

Answer 29

Under US GAAP and IFRS:
○ For public companies, goodwill is assumed to have an indefinite useful life and so is not amortized.
○ Goodwill tested annually for impairment or whenever there is an indication of potential impairment.
○ Impairment losses cannot be reversed.

Under US GAAP:
Private companies can choose to amortise

Question 30

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

Answer 30

Companies are assumed to continue operating into the foreseeable future and remain in existence indefinitely, as opposed to being liquidated.
Means that it continues generating cashflow from its assets

Question 31

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

Answer 31

The belief that it’s better to understate revenue or the value of assets than to overstate it.

Minimises the risk of overstatement.
For any revenue or expense to be recognized, there must be evidence of occurrence with a measurable monetary amount.

Question 32

What is historical cost under accrual accounting and why are most assets recorded at historical cost?

Answer 32

The principle that an asset’s value on the balance sheet should reflect the initial purchase price, not the market value.

Ensures consistency and reliability in measurements, no need for constant revaluations and markups.

Examples that are not: equity investments (marketable securities), or the value of derivative instruments.

Question 33

Why are internally developed intangible assets not recorded on a company’s balance sheet?

Answer 33

If they are internally generated then there is no measurable, objective transaction value from which they could be recorded.
Internally developed branding, trademarks, and intellectual property not recorded

Question 34

If the share price of a company increases by 10%, what is the balance sheet impact?

Answer 34

No impact. Shareholders’ equity on the balance sheet reflects the book value.

Equity value is the market capitalisation and reflects the value ascribed to a company by the market.

Question 35

Do accounts receivable get captured on the income statement?

Answer 35

No, not directly.
Revenue from accounts receivable will be recorded in the topline in the income statement, however.

AND changes in the level (flow) of accounts receivable will be indirecty measured in net changes in working capital on the cash flow statement.

Question 36

What is deferred revenue?

Answer 36

Unearned revenue is a liability that represents payments received from customers for goods or services not yet delivered

E.g. gift cards, gym subscription paid upfront

Question 37

Why is deferred revenue a liability, but accounts receivable an asset?

Answer 37

Deferred revenue is a liability because the company owes an obligation to the customer: delivery or performance of the good or service.

Accounts receivable is an asset because it will generate a benefit to the firm (customer owes company cash payment)

Question 38

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

Answer 38

• Increases in accounts payables means that company has delayed payments to suppliers or vendors, so cash is still in the company’s possession.
  
  • The cash will eventually be paid, but until then, the company is free to use it how it wishes.
    It therefore reflects an inflow of cash on the cash flow statement.

Question 39

Which section of the cash flow statement captures interest expense?

Answer 39

The cash flow statement does not directly capture interest expense.

However, interest expense is captured in the income statement which hits net income, which is then carried into the cash flow statement through cash flow from operations

Question 40

What happens to the three financial statements if a company initiates a dividend?

Answer 40

IS: No impact

CFS: The cash flows from financing section will show an outflow of cash for the dividend

BS: Decrease in the cash balance on the asset side, offsetting entry decrease in retained earnings.

Question 41

Do inventories get captured on the income statement?

Answer 41

Not directly, but indirectly through COGS.

COGS reflects a portion of inventory that is used up during that period.

More useful is the balance sheet: inventory balance is recorded in current assets

And cash flow statement:
net inventory increase: bought more COGS than sold - cash decrease;
net inventory decrease: sold more COGS than bought - cash increase.

Question 42

How should an increase in inventory get handled on the cash flow statement?

Answer 42

Increase in inventory means more inventory has been bought than sold during the period
Represents an outflow of cash in the operations section of the cash flow statement.

Question 43

What is the difference between LIFO and FIFO, and what are the implications on net income?

Answer 43

First In, Last Out: Inventory purchased earlier is expensed first when sold

Last In, First out: Inventory purchased later is expensed first when sold

Rising inventory costs:
FIFO: lower COGS, less expensive inventory is recognised first
LIFO: higher COGS, more expensive inventory is recognised first
Falling inventory costs:
FIFO: higher COGS, more expensive inventory is recognised first
LIFO: lower COGS, less expensive inventory is recognised first

Question 44

How do you calculate retained earnings for the current period?

Answer 44

Retained earnings = Prior retained earnings balance + Net Income from end of current period - Dividends paid.

Question 45

What is the retention ratio and how is it related to the dividend payout ratio?

Answer 45

The retention ratio is the proportion net income retained by the company: (Net Income - Dividends)/Net Income

Opposite of this is the payout ratio, the proportion of net income paid out to shareholders: Dividends/Net Income

Question 46

What are two ways to calculate earnings per share?

Answer 46

Basic EPS: earnings per share on common stock

(Net Income - Preferred Share Dividends) / # Weighted Average of Basic Shares Outstanding (Shares at beginning of period, adjusted for changes, weight each share by the fraction of the year that the shares were outstanding)

Diluted EPS: earnings per share not just on common stock, but also on potentially dilutive securities such as stock options:
(Net Income - Preferred Share Dividends) / # Weighted Average of Dilutive Shares Outstanding

We subtract preferred share dividends from net income because we only want to capture the earnings available to common shareholders.