Accounting: Conceptual Questions

Question 1

What are the three financial statements, and why do we need them?

Answer 1

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

The Income Statement shows the company’s revenue, expenses, and taxes over a period and ends with Net Income, which represents the company’s after-tax profits.

The Balance Sheet shows the company’s Assets – its resources – as well as how it paid for those resources – its Liabilities and Equity – at a specific point in time. Assets must equal Liabilities plus Equity.

The Cash Flow Statement begins with Net Income, adjusts for non-cash items and changes in operating assets and liabilities (working capital), and then shows the company’s Cash Flow from Investing and Financing activities; the last lines show the net change in cash and the company’s ending cash balance.

You need the financial statements because there’s always a difference between the company’s Net Income and the real cash flow it generates, and the statements let you estimate the cash flow more accurately.

Question 2

How do the financial statements link together?

Answer 2

To link the statements, make Net Income from the Income Statement the top line of the Cash Flow Statement.

Then, adjust this Net Income number for non-cash items such as Depreciation & Amortization.

Next, reflect changes to operational Balance Sheet items such as Accounts Receivable, which may increase or reduce the company’s cash flow.

This gets you to Cash Flow from Operations.

Next, include investing and financing activities, which may increase or reduce cash flow, and sum up Cash Flow from Operations, Investing, and Financing to get the net change in cash at the bottom.

Cash at the bottom of the CFS becomes Cash on the Balance Sheet, and Net Income, Stock Issuances, Stock Repurchases, Stock-Based Compensation, and Dividends link into Common Shareholders’ Equity.

Next, link the separate line items on the CFS to their corresponding Balance Sheet line items; for example, CapEx and Depreciation link into Net PP&E.

When you’re on the Assets side of the Balance Sheet, and you’re linking to the Cash Flow Statement, subtract CFS links; add them on the L&E side.

Finally, check that Assets equals Liabilities plus Equity at the end.

Question 3

What’s the most important financial statement?

Answer 3

The Cash Flow Statement is the most important single statement because it tells you how much cash a company is generating, and valuation is based on cash flow.

The Income Statement includes non-cash revenue, expenses, and taxes, and excludes cash spending on major items such as Capital Expenditures, so it does not accurately represent a company’s cash flow.

Question 4

Could you use only two financial statements to construct the third one? If not, why not?

Answer 4

It depends on which two statements you pick.

For example, you could use the Income Statement and “Starting” and “Ending” Balance Sheets to construct the Cash Flow Statement, but there may be ambiguity (e.g., you know how Net PP&E changes, but you’re not sure of the CapEx vs. Depreciation split).

Potentially, you could also use the Income Statement and Cash Flow Statement to move from the “Starting” Balance Sheet to the “Ending” one (but also with some ambiguity).

However, it would be nearly impossible to construct the Income Statement starting with just the Balance Sheet and Cash Flow Statement because there aren’t enough direct links.

Question 5

How might the financial statements of a company in the U.K. or Germany be different from those of a company based in the U.S.?

Answer 5

Income Statements and Balance Sheets tend to be similar across different regions, but companies that use IFRS often start the Cash Flow Statement with something other than Net Income: Operating Income, Pre-Tax Income, or if they are using the Direct Method for creating the CFS, Cash Received or Cash Paid.

IFRS-based companies also tend to place items in more “random” locations on the CFS, so you may need to rearrange it.

Finally, the Operating Lease Expense is split into Interest and Depreciation elements under IFRS, but it’s recorded as a simple Rental Expense under U.S. GAAP.

Question 6

What should you do if a company’s Cash Flow Statement starts with something OTHER than Net Income, such as Operating Income or Cash Received?

Answer 6

For modeling and valuation purposes, you should convert this Cash Flow Statement into one that starts with Net Income and makes the standard adjustments.

Large companies should provide reconciliations that show you how to move from Net Income or Operating Income to Cash Flow from Operations and that list the Change in Working Capital and other non-cash adjustments.

If the company does NOT provide that reconciliation, you might have to use the CFS in its original format and use simpler methods to project it.

Question 7

How do you know when a revenue or expense line item should appear on the Income Statement?

Answer 7

To appear on the Income Statement, an item must:

1) Correspond 100% to the period shown – Revenue and expenses are based on the delivery of products or services, so an item delivered in Year 1 can count only in Year 1. And if a company buys a factory, it can’t list that purchase on the Income Statement because it will be useful for many years. It corresponds to more than just this period.
2) Affect the business income available to common shareholders (Net Income to Common) – If something does not affect the owners of the business, it should not appear on the Income Statement.

The second point explains why Preferred Dividends appear on the Income Statement: they reduce the after-tax profits that could potentially go to common shareholders.

Question 8

What’s the difference between Assets, Liabilities, and Equity line items on the Balance Sheet?

Answer 8

There’s no precise, universal definition, but an Asset is something that will result in a future benefit for the company, such as future cash flow, business growth, or tax savings.

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

Liabilities are usually related to external parties – lenders, suppliers, or the government – while Equity line items are usually related to the company’s internal operations.

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

Question 9

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

Answer 9

You list an item on the Cash Flow Statement if:

1) It has already appeared on the Income Statement and affected Net Income, but it’s noncash, so you need to adjust to determine the company’s real cash flow; OR
2) It has NOT appeared on the Income Statement, and it DOES affect the company’s cash balance.

In category #1 are items such as Depreciation and Amortization; Category #2 includes items in Cash Flow from Investing and Financing, such as Capital Expenditures and Dividends.

Changes in Working Capital could fall into either category (e.g., an increase in AR is in category #1, but a decrease in AR is in category #2).

Question 10

A company uses cash accounting (i.e., it only records revenue when it is received in cash and only records expenses when they are paid in cash) rather than accrual accounting.

A customer buys a TV from the company “on account” (i.e., without paying upfront in cash) and receives the TV right away. How would the company record this transaction differently from a company that uses accrual accounting?

Answer 10

Under cash accounting, the Revenue would not show up until the company collects the cash from the customer – at which point it would increase Revenue on the Income Statement (and Pre-Tax Income, Net Income, etc.) and Cash on the Balance Sheet.

Under accrual accounting, the sale would show up as Revenue right away, but instead of increasing Cash on the Balance Sheet, it would increase Accounts Receivable at first. Then, once the company collects the cash payment from the customer, Accounts Receivable would decrease, and Cash would increase.

Question 11

A company begins offering 12-month installment plans to customers so that they can pay for $1,000 products over a year instead of 100% upfront. How will its cash flow change?

Answer 11

In the short term, the company’s cash flow is likely to decrease because some customers will no longer pay 100% upfront.

So, a $1,000 payment in Month 1 now turns into $83 in Month 1, $83 in Month 2, and so on.

The long-term impact depends on how much sales grow as a result of this change.

If sales grow substantially, that might be enough to offset the longer cash-collection process and increase the company’s overall cash flow.

Question 12

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

Will this prepayment boost the company’s cash flow?

Answer 12

In the short term, no, because the company is now paying 12 * Monthly Rent in a single month rather than making one cash payment per month.

On the Income Statement in Month 1, the company will still record only the Monthly Rent for that month. But on the Cash Flow Statement, it will record –12 * Monthly Rent under “Change in Prepaid Expenses” to represent the cash outflow.

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

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

Question 13

Your friend is analyzing a company and says that you always have to look at the Cash Flow Statement to find the full amount of Depreciation. Is he right?

Answer 13

Yes, your friend is correct. This happens because companies often embed Depreciation within other line items on the Income Statement, such as COGS and Operating Expenses.

For example, employees in marketing, research, and customer support might all be using computers, so the Depreciation of computers would be embedded in expense categories like Sales & Marketing, Research & Development, and General & Administrative.

Question 14

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 14

A company collects cash payments for a monthly service long in advance if 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 several months or a year into the future.

This practice always boosts a company’s cash flow. It corresponds to Deferred Revenue, and on the CFS, an increase in Deferred Revenue is a positive entry that boosts a company’s cash flow. When this cash is finally recognized as Revenue, Deferred Revenue declines, which appears as a negative entry on the CFS.

Question 15

Why is Accounts Receivable (AR) an Asset, but Deferred Revenue (DR) a Liability?

Answer 15

AR is an Asset because it provides a future benefit to the company – the receipt of additional cash from customers in the future.

DR is a Liability because it results in future obligations for the company. The company has already collected all the cash associated with the sale, so now it must deliver the product or service, and it must spend something to do that.

AR and DR are the opposites of each other: AR has not yet been collected in cash but has been delivered, whereas DR has been collected in cash, but has not yet been delivered.

Question 16

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

Answer 16

Prepaid Expenses have already been paid in cash but have not yet been incurred as expenses, so they have not appeared on the Income Statement.

When they finally appear on the Income Statement, they’ll effectively be “non-cash expenses” that reduce the company’s taxes, which makes them an Asset.

By contrast, Accounts Payable have not yet been paid in cash.

When the company finally pays them, its Cash balance will decrease, which makes AP a Liability. Accounts Payable and Accrued Expenses work the same way, but Accounts Payable is used for specific items with invoices (e.g., legal bills), while Accrued Expenses is used for monthly, recurring items without invoices (e.g., utilities).

Accrued Expenses almost always result in an Income Statement expense before being paid in cash, and Accounts Payable often do as well.

However, in some cases, Accounts Payable may correspond to items that have not yet appeared on the Income Statement, such as purchases of Inventory made on credit.

Question 17

Your CFO wants to start paying employees mostly in Stock-Based Compensation, under the logic that it will reduce the company’s taxes, but not “cost it” anything in cash.

Is the CFO correct? And how does Stock-Based Compensation impact the statements?

Answer 17

The CFO is correct on a superficial level, but not in reality.

First, the full amount of Stock-Based Compensation is not deductible for Cash-Tax purposes when it is initially granted in most countries, so even if Book Taxes decrease, Cash Taxes may not change at all.

The eventual tax deduction will take place much further into the future when employees exercise their options and/or receive their shares.

But the other problem with the CFO’s claim is that Stock-Based Compensation creates additional shares, diluting existing investors and, therefore, “costing” the company something. That makes it quite different from non-cash expenses that do not change the company’s capital structure, such as Depreciation and Amortization.

Question 18

A junior accountant in your department asks about the different ways to fund the company’s operations via external sources and how they impact the financial statements. What do you say?

Answer 18

The two main methods of funding a company’s operations with outside money are Debt and Equity. Debt is initially cheaper for most companies, so most companies prefer to use Debt… up to a reasonable level.

To do this, the company must be able to service its Debt by paying for the interest expense and possible principal repayments; if it can’t do that, it must use Equity instead.

Both Equity and Debt issuances show up only on the Cash Flow Statement initially (in Cash Flow from Financing), and they boost the company’s Cash balance.

With Equity, the company’s share count increases immediately after issuance, which means that existing investors get diluted (i.e., they own a smaller percentage of the company).

With Debt, the company must pay interest, which will be recorded on its Income Statement, reducing its Net Income and Cash, and it must eventually repay the full balance.

Question 19

Your company decides to sell equipment for a market value of $85. The equipment was listed at $100 on your company’s Balance Sheet, so you have to record a Loss of $15 on the Income Statement, which gets reversed as a non-cash expense on the Cash Flow Statement.

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

Answer 19

This 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. It’s not as if you’ve “lost” or “spent” $15 in cash because you sold the equipment at a reduced price.

The Loss means that 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 20

Your company owns an old factory that’s currently listed at $1,000 on its Balance Sheet. Why would it choose to “write down” this factory’s value, and what is the impact on the financial statements?

Answer 20

A company might write down an Asset if its value has declined substantially, and its current Book Value (the number on the Balance Sheet) is no longer accurate.

For example, maybe the factory is damaged by a hurricane, or new technology makes the factory obsolete.

On the statements, you record this write-down as an expense on the Income Statement, but you add it back as a non-cash expense on the Cash Flow Statement.

Typically, these write-downs are not deductible for Cash-Tax purposes, so you also record a negative adjustment under Deferred Taxes on the CFS.

Net PP&E decreases, and the Deferred Tax Asset increases. On the L&E side of the Balance Sheet, Common Shareholders’ Equity decreases due to the reduced Net Income.

Question 21

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

Answer 21

A company might purchase financial investments if it has excess Cash and cannot think of other ways to use it.

For example, the company can’t hire more employees, buy more equipment or factories, or acquire other companies, and it also doesn’t want to issue Dividends to investors, repurchase stock, or repay Debt.

The initial purchase of these investments will show up only on the Cash Flow Statement (in Cash Flow from Investing) and will reduce the company’s cash flow.

Afterward, the Interest Income earned on these investments will appear on the Income Statement and boost the company’s Pre-Tax Income, Net Income, and its Cash balance.

Question 22

Could a company have negative Common Shareholders’ Equity (CSE) on its Balance Sheet? If no, why not? If yes, what would it mean?

Answer 22

Yes, it could. Just think about the main items that link into CSE: Net Income and Dividends. If a company’s Net Income is repeatedly negative, CSE will eventually turn negative.

Negative Common Shareholders’ Equity is almost always a negative sign because it means the company has been unprofitable, repeatedly, or it has issued too much in Dividends or repurchased too many shares.

It’s more acceptable for tech and biotech startups that lose significant money in their early years, so you will see negative CSE figures there, but eventually, they should turn positive.

Question 23

Your firm recently acquired another company for $1,000 and created Goodwill of $400 and Other Intangible Assets of $200 on the Balance Sheet. A junior accountant in your department asks you why the company did this – how would you respond?

Answer 23

You need to create Goodwill and Other Intangible Assets after an acquisition takes place to ensure that the Balance Sheet balances.

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

If you’ve paid exactly what the seller’s CSE is worth – e.g., you paid $1,000 in cash, and the seller has $1,000 in CSE, then there are no problems.

The combined Cash balance decreases by $1,000, and so does the combined CSE.

However, in real life, acquirers almost always pay premiums for target companies, which means that the Balance Sheet will go out of balance.

For example, if the seller here had $400 in CSE, the Balance Sheet would have gone out of balance immediately because the Assets side would have decreased by $1,000, but the L&E side would have decreased by only $400.

To fix that problem, you start by allocating value to the seller’s “identifiable intangible assets” such as patents, trademarks, intellectual property, and customer relationships. In this case, we allocated $200 to these items.

If there’s still a gap remaining after that, you allocate the rest to Goodwill, which explains the $400 in Goodwill here.

Question 24

How do Goodwill and Other Intangible Assets change over time?

Answer 24

Goodwill remains constant unless it is “impaired,” i.e., the acquirer decides that the acquired company is worth less than it initially expected and writes down the Goodwill. That appears as an expense on the Income Statement and a non-cash adjustment on the Cash Flow Statement. Other Intangible Assets amortize over time (unless they are indefinite-lived), and that Amortization shows up on the Income Statement and as a non-cash adjustment on the Cash Flow Statement. The balance 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 25

How do Operating Leases and Finance Leases (Capital Leases) appear on the financial statements? Explain the high-level treatment as well as IFRS vs. U.S. GAAP differences.

Answer 25

Assets and Liabilities associated with leases that last for more than 12 months now appear directly on companies’ Balance Sheets. Operating Lease Assets are sometimes called “Right-ofUse Assets,” and Operating Lease Liabilities initially match them on the other side.

The rental expense for Finance Leases, which give companies an element of ownership or a “bargain purchase option” at the end, is split into Interest and Depreciation elements on the Income Statement.

On the Cash Flow Statement, Depreciation is added back, and under Cash Flow from Financing, the company records a negative for the “Repayment of Lease Principal” (or similar name).

On the Balance Sheet, both the Lease Assets and Lease Liabilities decrease each year until the lease ends.

Under IFRS, Operating Leases and Finance Leases are treated the same way, so the Operating Lease Expense is also split into Interest and Depreciation elements, and the same BS and CFS line items change.

For Operating Leases under U.S. GAAP, companies record a simple Lease or Rental Expense on the Income Statement, so there is no Depreciation/Interest split.

However, the Lease Assets and Lease Liabilities on the Balance Sheet still decrease each year based on the “Depreciation” and “Lease Principal Repayment” the company estimates.

Question 26

What’s the difference between Deferred Tax Assets and Deferred Tax Liabilities, and how are Net Operating Losses (NOLs) related to both of them?

Answer 26

Both DTAs and DTLs relate to temporary differences between the book basis and the tax basis of assets and liabilities.

Deferred Tax Assets represent potential future cash-tax savings for the company, while Deferred Tax Liabilities represent additional cash-tax payments in the future.

DTLs often arise because of different Depreciation methods, such as when companies accelerate Depreciation for tax purposes, reducing their tax burden in the near term but increasing it in the future. They may also be created in acquisitions.

DTAs may arise when the company loses money (i.e., negative Pre-Tax Income) in the current period and, therefore, accumulates a Net Operating Loss (NOL). They are also created when the company deducts an expense for Book-Tax purposes but cannot deduct it at the same time for Cash-Tax purposes (e.g., Stock-Based Compensation).

NOLs are a component of the DTA; the NOL component of the DTA is approximately equal to the Tax Rate * NOL Balance.

Question 27

What are some items that are deductible for Book-Tax but not Cash-Tax purposes, and how do they affect the Deferred Tax line items?

Answer 27

Examples include Stock-Based Compensation (when initially granted), the Amortization of Intangibles, and various Write-Downs and Impairments (for Goodwill, PP&E, etc.).

These items reduce a company’s Book Taxes (the number that appears on the Income Statement), but they do not save the company anything in Cash Taxes.

So, the Deferred Tax line item on the CFS will show a negative for these items, reducing the company’s cash flow, and the DTA will increase.

These items become Cash-Tax Deductible only when “Step 2” of the process happens – such as the company selling PP&E that has been written down, or the employees exercising their options and receiving their shares in the company.

Question 28

Suppose that you’re analyzing a company, and you want to project its financial statements. Before projecting anything, how would you simplify its statements first?

Answer 28

On the Income Statement, you might split up Revenue and Expense differently or show Depreciation & Amortization as separate line items to make the projections easier.

On the Balance Sheet, it’s best to aim for 5-10 items, at most, on each side. Combine “Short-Term” and “Long-Term” versions of items, make a single Net DTA or Net DTL, and list just one line for Common Shareholders’ Equity. Combine all smaller/miscellaneous items.

On the Cash Flow Statement, consolidate the smaller/miscellaneous items between Net Income and the Change in Working Capital. You don’t want ~15 lines there; aim for D&A, Deferred Taxes, and maybe 1-2 others.

In the CFI and CFF sections, combine smaller items related to purchasing and selling securities and paying fees on capital raised, and focus on the core items: CapEx, Equity and Debt Issuances, Stock Repurchases, Debt Repayments, and Dividends.