Accounting Guide - BIWS

Question 1

What criteria must items meet to be on the income statement?

Answer 1

Must affect the company’s taxes and correspond to the period shown on the income statement.

Question 2

Describe the items shown on a company’s balance sheet?

Answer 2

Shows a company’s resources and how it acquired them at a specific point in time

Question 3

How is the value decided for Common Stock and Additional Paid-In Capital?

Answer 3

Represents the market value of the shares at the time they were issued by the company. It does not change.

Question 4

What is treasury stock?

Answer 4

Stock repurchased from investors, at the value it was purchased at.

Question 5

How is SCF different from IS?

Answer 5

The SCF exists to adjust for non-cash revenue and expenses that may have been included on the IS. There may also be additional inflows and outflows not appearing on the IS, such as CapEx and Dividends. SCF has three sections: CFO, CFI, CFF.

Question 6

How are the three statements linked?

Answer 6

1. Net Income from the bottom of the IS appears at the top line of SCF. 2. Non-cash expenses from the IS are added back (ie. depreciation, impairment, unrealized gain/loss). 3. Changes in operational balance sheet items are reflected. If an asset goes up, cash flow goes down. If liabilities go up, cash goes up. 4. Purchases and Sales of investments are in CFI. 5. Dividends, debt issued or repurchased, shares issued or repurchased are reflected in CFF. 6. Net change in cash at the bottom of SCF is cash at the top of the next periods balance sheet.
2. Update balance sheet to reflect changes in cash, debt, equity, investments, PPE and anything else in the SCF.

Question 7

What changes as a result of revenue, operating expenses or interest income/expense being adjusted?

Answer 7

Pre-tax income, net income, cash, retained earnings. The balance sheet is balanced by cash and retained earnings both being adjusted.

Question 8

What is the opposite of prepaid expenses?

Answer 8

Accrued expenses

Question 9

What’s the difference between accounts receivable and deferred revenue?

Answer 9

When deferred revenue goes up it means we have collected the cash from customers but haven’t yet completed the service/product delivery. When AR goes up it means we have completed the service/product delivery but haven’t yet been paid.

Question 10

What happens when a company purchases or sells securities, capex adjusted, sells PPE, raises debt, pays of debt, issues stock, etc.?

Answer 10

These are examples of non-operational balance sheet and SCF items. Cash and the corresponding balance sheet item would be adjusted.

Question 11

Walk me through the three financial statements.

Answer 11

The three major statements are the income statement, balance sheet and statement of cash flow. The IS shows the companies revenue and expenses over a specified period of time. The balance sheet shows the companies resources - their assets and labilities, and shareholders equity at a specific point in time. Assets must equal liabilities plus shareholders equity. The SCF begins with net income and adjusts for non-cash expenses and changes in operating assets and liabilities (working capital). It then shows how the company has spent or received cash through investing and financing. At the end, the company’s net change in cash over the period is shown.

Question 12

Give examples of line items on each financial statement.

Answer 12

IS: Revenue, operating expenses, general expenses, COGS, operating income, pre tax income and net income. BS: Cash, AR, AP, Inventory, PPE, Debt, Shareholders equity. SCF: Cash flow from operations (Net income, depreciation, changes in operating assets/liabilities), cash flow from investing (capex, sale of PPE), Cash flow from financing (dividends paid, debt raised or paid off, shares issues, etc.

Question 13

Describe how the statements link together.

Answer 13

Net income from the IS becomes the top line of SCF. Then, any non-cash charges like D&A are added back to net income. Next, changes to operational BS items appear and either reduce or increase CF depending whether they are assets or liabilities. That gets you to CFO. Next, investing and financing activities are accounted for - changes to items like PPE and Debt on the BS - will increase or decrease CF. At the bottom is net change in cash. On the balance sheet for the end of the period, cash at the top equals the beginning cash number (from the start) plus the net change in cash from the SCF statements. Net income flows into shareholders equity to make the BS balance because assets must always equal shareholders equity plus liabilities.

Question 14

If a non-cash expense is shown on the IS, why would the entire expense on the SCF be added back?

Answer 14

To reflect the tax savings (it is tax deductible).

Question 15

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

Answer 15

If the asset has a useful life over one year it is capitalized (put on the balance sheet) and depreciated.

Question 16

Debt repayments are shown in SCF, why aren’t interest payments also shown?

Answer 16

Interest payments correspond to a specific period and are tax deductible.

Question 17

What does negative operating working capital mean?

Answer 17

Some companies with subscriptions or LT contracts have negative working capital balances because of high deferred revenue… Other retail companies may also have negative working capital because their customers pay up front but they wait months to pay their suppliers.

Question 18

What’s the difference between prepaid expenses and AP?

Answer 18

For prepaid expenses, the money is paid up front but the service/product hasn’t been delivered yet. For AP, we have received the product/service but haven’t paid yet.

Question 19

What does negative shareholder’s equity mean?

Answer 19

1. LBO with dividend recapitalization. It means the owner has taken out a large portion of its equity (usually in cash).
2. It can also happen when the company has consistently been losing money and has declining retained earnings. Often means the company is struggling

Question 20

If a company has positive EBITDA over ten years but goes bankrupt, how does this happen?

Answer 20

1. The company is spending too much on capital expenditures, these are not reflected in EBITDA but represent true cash expenses. 2. The company’s debt all matures on one date and it can’t refinance
2. High interest expense
3. significant one time charges

Question 21

Walk me through how depreciation would affect the statements ($10.00).

Answer 21

IS: Operating income and pre-tax income would decline by $10. However, depreciation is tax deductible so assuming a rate of 40%, Net income would decline by $6.

SCF: Net income at the top would be down by $6, but since depreciation is a non-cash expense it would be added back under CFO. So, overall cash flow would be up by $4 to reflect the tax savings. On the balance sheet, the asset would go down by $10 but cash would be up by $4. overall, the assets would decline by $6 and shareholders equity would be down by $6 so both sides balance.

Question 22

What happens if Accrued Expenses increase by $10?

Answer 22

Income statement: operating income and pre-tax income falls by $10, net income falls by $6, after tax deductible is accounted for.

SCF: Net income would be down by $6, and the increase in accrued expenses will increase cash flow by $10, so overall CFO is up by $4 and net change in cash at the bottom is up by $4.

Balance Sheet: Cash is up by $4 as a result, so assets are up by $4. On the liabilities and equity side, accrued expenses is a liability so liabilities are up by $10 and shareholders equity is down by $6 due to net income decreases so both sides balance.

Question 23

What happens when accrued expenses decrease by $10?

Answer 23

No changes on the income statement.

SCF: Accrued expenses in the CFO section would be -$10 because it is paid out in cash and so cash at the bottom decreases by $10.

BS: Cash would be down $10 on the assets side and accrued expenses is a liability and would also decline by $10, so it balances.

Question 24

What happens when AR increases by $10?

Answer 24

IS: revenue is up $10 and so is pre-tax income. After tax, net income is up $6.

SCF: Net income is up by $6 but increase in AR means reduction in cash (we haven’t been paid yet) so we have to subtract ten dollars. Which results is cash at the bottom being down by $4.

BS: Cash is down by $4, but AR increases by $10 so assets are up $6. On the other side, net income is up $6 so SE rises which means both sides balance.

Question 25

Prepaid expenses decrease by $10. Walk through statements.

Answer 25

IS: Pre-tax income is down by $10 and net income is down by $6.

SCF: Net income is down by $6 but since prepaid expenses is an asset, a decrease of $10 results in an increase of $10 in cash. At the bottom of SCF, cash is up by $4.

BS: On the assets side cash is up by $4, and prepaid expenses is down by $10 so assets side is down by $6 overall. On the other side, SE equity declines because NI is down by $6.

Question 26

What happens when inventory goes up by $10, assuming it’s paid for in cash?

Answer 26

IS: No change.

SCF: Inventory is an asset so it reduces CFO. Net change in cash is reduced by $10.

BS: Inventory is up by $10 but cash is down $10, so Nil change. Still balances.

Question 27

A company sells PPE for $120, on the BS it’s worth $100. Walk through statement changes.

Answer 27

IS: Record a gain on sale of $20, which boosts pre tax income. Assuming 40% tax rate, net income is up by $12.

SCF: Net income is up by $12, but gain on sale is subtracted from CFO, so CFO is down by $8. then, in CFI record the entire amount of the proceeds from the sale ($120).
Then, at the bottom of SCF, cash is up by $112.

BS: Cash is up by $112 but PPE is down by $100 since we have sold assets… so the assets side is up by $12. SE is also up $12 due to net income increase.

Gains and losses are non-cash expenses, but they are re-classified on the CFS…

Question 28

3 Statement impact when $100 worth of shares are issued to investors.

Answer 28

IS: No change. doesn’t effect taxes.

SCF: CFI is up by $100, so cash at the bottom is also up.

BS: Cash is up $100, Common stock is SE is also up by $100 to balance it.

Question 29

A company issues $100 in dividends, how do the statements change?

Answer 29

IS: No change

SCF: CFF down by $100 due to the dividends, so cash at the bottom is down by $100.

BS: Cash is down by $100 on assets size, on SE side retained earnings is down by $100 so balances.

Question 30

If a company purchases $100 in PPE with debt, how does this impact the statements at year 1?

Answer 30

IS: No change.

SCF: $100 of Capex (CFI), so decline in cash. $100 in Debt, so CFF increases by $100. So cash number remains the same here.

BS: PPE is up $100 and debt is up $100 so both sides balance.

Question 31

Company bought $100 in PPE in Year 1 and it is now year 2. debt was used to purchase and it is high yield (10% interest), no principle being paid just interest. The PPE depreciates at 10% per year.

Answer 31

IS: $10 in interest expense, $10 in depreciation expense. Pre tax income is down $20, but both items are tax deductible so net income on declines by $12.

SCF: Depreciation is added back since it is a non-cash expense. So cash is down by $2.

Balance Sheet: Asset declines by $10 and cash is down by $2. so overall assets side is down by $12. On the other side, net income is down by $12 so SE is down 12 which means it balances.

Question 32

What are examples of non-recurring charges we need to add back to a company’s EBIT / EBITDA when analyzing financial statements?

Answer 32

RX Charges, Goodwill impairment, asset write downs, bad debt expenses

Question 33

How do net operating losses (NOLs) affect a company’s three statements?

Answer 33

Reduce the taxable income by the portion of the NOLs that you can use each year, apply the same tax rate, and then subtract that new tax number from your old pre-tax number. Then you can deduct whatever used up from NOL balance (which should be part of deferred tax asset line item)