Accounting - Multi-Step Change Flashcards
A company buys a factory for $200 using $200 of Debt. What happens INITIALLY on the statements?
- Income Statement: No changes.
- Cash Flow Statement: There’s no net change in cash because the $200 factory purchase counts as CapEx, which reduces cash flow, and the $200 Debt issuance is a cash inflow.
- Balance Sheet: PP&E is up by $200, so the Assets side is up by $200, and Debt is up by $200, so the L&E side is up by $200, and the Balance Sheet stays balanced.
- Intuition: An Asset increases and a Liability increases to balance it, and there are no tax effects.
One year passes. The company pays 10% interest on its Debt, and it depreciates 10% of the factory. It also repays 5% of the Debt principal. What happens on the statements in this first year?
A 10% interest rate means $20 in Interest Expense, the 10% depreciation means $200 * 10% = $20 of Depreciation, and 5% * $200 = $10 of the Debt principal is repaid. So:
• Income Statement: You record $20 in Interest and $20 in Depreciation, so Pre-Tax Income falls by $40, and Net Income falls by $30 at a 25% tax rate.
• Cash Flow Statement: Net Income is down by $30, but you add back the $20 of Depreciation and record $10 in Debt Principal Repayments, so Cash at the bottom is down by $20.
• Balance Sheet: Cash is down by $20, and Net PP&E is down by $20, so the Assets side is down by $40. On the L&E side, Debt is down by $10 due to the principal repayment, and CSE is down by $30 due to the reduced Net Income, so both sides are down by $40 and balance.
• Intuition: Cash declines because of the Interest Expense and Debt Principal Repayment, offset by the tax savings from the Interest and Depreciation.
At the end of this first year, the company sells its factories for $220 and uses the proceeds to repay its remaining Debt principal, after realizing there is little demand for its products. Walk through this step SEPARATELY from the previous two. Assume that the Net PP&E balance is $180, and the Debt is $190 because of changes in the previous step.
The Net PP&E selling price is $220, and its Book Value is $180, so we record a Gain of $40:
• Income Statement: The Realized Gain of $40 increases Pre-Tax Income by $40 and Net Income by $30 at a 25% tax rate.
• Cash Flow Statement: Net Income is up by $30, but the $40 Gain is non-cash, so it’s reversed in the CFO section. Then, in Cash Flow from Investing, the full sale proceeds of $220 are recorded as a cash inflow. In Cash Flow from Financing, the $190 Debt repayment is shown as a negative. So, Cash at the bottom is up by $20.
• Balance Sheet: Cash is up by $20, and Net PP&E is down by $180, so Total Assets are down by $160. On the L&E side, Debt is down by $190, and CSE is up by $30 because of the increased Net Income, so both sides are down by $160 and balance.
• Intuition: Cash is up because of the Gain, which boosts Cash by $30 after taxes. However, the full $30 does not flow into Cash because the Debt Repayment exceeds the reduction in Net PP&E by $10. As a result, Cash is up by $20 instead of $30.
Walmart orders $200 of Inventory and pays for it using Debt. What happens on the statements immediately after this initial transaction?
- Income Statement: No changes.
- Cash Flow Statement: Inventory is up by $200, which reduces cash flow by $200, but the Debt issuance boosts cash flow by $200, so Cash at the bottom stays the same.
- Balance Sheet: The Assets side is up by $200 because Inventory is up by $200. The L&E side is also up by $200 because Debt is up by $200, so both sides balance.
- Intuition: This is a simple cash payment for an expense not yet incurred, combined with a Debt issuance that offsets the cash outflow.
A year passes, and Walmart sells the $200 of Inventory for $400. However, it also has to hire additional employees for $100 to process and deliver the orders (counted as OpEx). The company also pays 4% interest on its Debt and repays 10% of the principal. What happens on the statements over this year? Combine this step with the previous one and explain the changes from beginning to end.
This question is the standard “Sell Inventory for a certain amount of Revenue” one, but there are a few twists. For one, there’s also $100 in additional Operating Expenses. Also, you need to factor in the $8 Interest Expense on the Debt ($200 * 4%) and the $20 Debt Principal Repayment ($200 * 10%).
• Income Statement: Revenue is up by $400, but COGS is up by $200, and OpEx is up by $100, so Operating Income is only up by $100. There’s $8 in Interest Expense as well, so Pre-Tax Income is up by $92. At a 25% tax rate, Net Income is up by $69 (mental math: $100 * 75% = $75, and $8 * 75% = $6, so take $75 and subtract $6).
• Cash Flow Statement: Net Income is up by $69. But now we reverse the previous increase in Inventory, so the Change in Inventory is $0 once again. The $200 cash inflow for Debt still exists, but now there’s also a $20 Debt Principal Repayment so Cash at the bottom is up by $249.
• Balance Sheet: Cash is up by $249, and Inventory returns to its original level, so the Assets side is up by $249. On the L&E side, Debt is up by $180, and CSE is up by $69 due to the increased Net Income, so both sides are up by $249 and balance.
• Intuition: The company has bought goods, turned them into finished products, and recorded $75 in after-tax profits from the sale. However, its Cash balance increases by only $49 due to the Interest Expense on the Debt it used to purchase this Inventory as well as the Debt Principal Repayment.
Walk through the same scenario, but assume that Walmart purchases the $200 of Inventory on credit (i.e., Accounts Payable), sells it for $400, and still records $100 in additional OpEx. Assume that it pays the suppliers in the second step of this process.
Remember that Accounts Payable is not necessarily linked to a specific Income Statement line item in a case like this! It could just correspond to the company paying for Inventory on credit. In the first step:
• Income Statement: No changes.
• Cash Flow Statement: Accounts Payable increases, increasing cash flow by $200, and Inventory also increases, reducing cash flow by $200; the changes offset each other, and Cash at the bottom stays the same.
• Balance Sheet: Inventory on the Assets side is up by $200, and Accounts Payable on the L&E side is up by $200, so both sides are up by $200 and balance.
• Intuition: The company receives the parts and materials, but has not paid for them in cash yet, so the Balance Sheet changes but Cash stays the same.
And then in the second step:
• Income Statement: Revenue is up by $400, COGS is up by $200, and OpEx is up by $100, so Pre-Tax Income is up by $100. Net Income is up by $75 at a 25% tax rate.
• Cash Flow Statement: Net Income is up by $75, and the Change in Inventory and Change in Accounts Payable both reverse now, so Cash at the bottom is up by $75.
• Balance Sheet: Cash is up by $75 on the Assets side, and Inventory returns to its original level, so Total Assets are up by $75. On the L&E side, AP returns to its original level, and CSE is up by $75 due to the increased Net Income, so both sides are up by $75 and balance.
• Intuition: From beginning to end, this is a simple increase of $100 in Pre-Tax Income, so the company’s Cash balance goes up by $75 due to taxes.
A company issues $200 in Preferred Stock to buy $200 in Financial Investments. The Preferred Stock has a coupon rate of 8%, and the Financial Investments yield 10%. What happens on the statements IMMEDIATELY after the initial purchase?
- Income Statement: No changes.
- Cash Flow Statement: The purchase of the Financial Investments counts as an Investing Activity and reduces cash flow by $200, but the Preferred Stock issuance boosts cash flow by $200 within CFF, so there’s no net change in cash.
- Balance Sheet: Financial Investments is up by $200, so the Assets side is up by $200, and Preferred Stock on the other side is up by $200, so the L&E side is up by $200, and both sides balance.
- Intuition: This is a simple cash purchase of investments funded by a Preferred Stock issuance, and neither event affects the company’s taxes.
What happens on the statements after a year? Combine this step with the previous one, so that you factor in the increases in Financial Investments and Preferred Stock.
Although you subtract Preferred Dividends from Net Income to calculate Net Income to Common, the Preferred Dividends are NOT tax-deductible:
• Income Statement: The company records 10% * $200 = $20 in Interest Income from the Financial Investments, so Pre-Tax Income is up by $20, and Net Income is up by $15 at a 25% tax rate. The Preferred Dividends equal 8% * $200 = $16, so Net Income to Common is down by $1 after subtracting these.
• Cash Flow Statement: Net Income to Common is down by $1, and the Financial Investment and Preferred Stock increases still appear on the CFS and offset each other, so Cash at the bottom is down by $1.
• Balance Sheet: Cash is down by $1, and Financial Investments are up by $200, so the Assets side is up by $199. On the L&E side, Preferred Stock is still up by $200, and CSE is down by $1 because of the reduced Net Income to Common, so both sides are down by $199 and balance.
• Intuition: The point of this question is that the tax treatment of funding sources can make a significant impact on the statements. Since the Preferred Dividends are not tax-deductible, the company’s Cash balance falls; if they had been tax-deductible, its Cash balance would have risen. Also, note that Preferred Dividends do not reduce Preferred Stock – they reduce Common Shareholders’ Equity!
A company wants to boost its EPS artificially, so it decides to issue Debt and use the proceeds to repurchase common shares. Initially, the company has 1,000 shares outstanding at $1.00 per share and a Net Income of $300. What happens IMMEDIATELY after the company raises $200 in Debt and uses it to repurchase $200 in common stock?
Repurchasing $200 in stock at a share price of $1.00 per share means that the company repurchases 200 shares, so its share count drops from 1,000 to 800. Its EPS before this move was $300 / 1,000, or $0.30. For the first step:
• Income Statement: No changes.
• Cash Flow Statement: The $200 Debt issuance boosts cash flow by $200, but the $200 stock repurchase reduces it by $200, so there’s no net change in cash.
• Balance Sheet: There are no changes on the Asset side. On the L&E side, Debt is up by $200, but Treasury Stock within CSE is down by $200, so there’s no net change, and the BS remains in balance.
• Intuition: These are simple cash inflows and outflows that cancel each other out and make no impact on the company’s taxes.
What happens after a year passes if the company pays 4% interest on the Debt? Combine this with the first step and explain the EPS impact.
This question is a twist on the standard 3-statement accounting questions because you also have to calculate the change in EPS:
• Income Statement: The company records 4% * $200 = $8 in Interest Expense, so Pre-Tax Income is down by $8, and Net Income is down by $6 at a 25% tax rate. Net Income is now $294 rather than $300, and the Share Count decreased from 1,000 to 800 in Step 1. Therefore, EPS increases because the EPS numerator falls by 2%, but the denominator falls by 20% (it’s a $0.07 increase, but you can just say, “EPS increases”).
• Cash Flow Statement: Net Income is down by $6, and the Debt Issuance and Stock Repurchase still offset each other, so Cash at the bottom is down by $6.
• Balance Sheet: Cash is down by $6, so the Assets side is down by $6. On the L&E side, Debt is still up by $200, CSE is down by $200 due to the Stock Repurchase, and then it drops by another $6 due to the reduced Net Income, so the L&E side is also down by $6, and both sides balance.
• Intuition: Companies can artificially inflate their EPS with these tactics, so they may “look better” even if their cash flow and Cash balances both decrease. Don’t trust EPS!
Your company decides to acquire another company for $500, using 50% Debt and 50% Common Stock. The other company has $300 in Assets, no Liabilities, and $300 in Common Shareholders’ Equity. Assume that the purchase premium is distributed 50/50 between Goodwill and Other Intangible Assets. What happens to your company’s financial statements immediately after this acquisition takes place?
You combine the other company’s Assets and Liabilities with your company’s, and you write down the seller’s Common Shareholders’ Equity:
• Income Statement: No changes.
• Cash Flow Statement: You record a negative $500 for “Acquisitions” in Cash Flow from Investing and a positive $250 for Debt Issuances and positive $250 for Common Stock Issuances under Cash Flow from Financing. Cash at the bottom is unchanged.
• Balance Sheet: Cash stays the same, but you add the $300 in Acquired Assets, as well as the $100 in Goodwill and $100 in Other Intangible Assets, so the Assets side is up by 141 of 149 https://breakingintowallstreet.com
$500. On the other side, Debt is up by $250, and CSE is up by $250, so the L&E side is also up by $500, and both sides balance.
• Intuition: Immediately after the deal closes, the main changes take place on the Balance Sheet; Cash does not change because the acquisition was funded completely with Debt and a Stock Issuance.
Now, walk through what happens on the statements in the one year following this acquisition. The acquired company contributes $200 in Revenue and $100 in OpEx, and the Interest Rate on Debt is 8%. Assume that the Other Intangible Assets have a useful life of 5 years. Walk through ONLY THIS STEP, and do not worry about tracking the cumulative changes with the previous one.
- Income Statement: Revenue is up by $200, but OpEx is up by $100, and there’s now $100 / 5 = $20 of Amortization of Intangibles and $250 * 8% = $20 of Interest Expense. So, Pre-Tax Income is up by $100 – $20 – $20 = $60. At a 25% tax rate, Net Income is up by $45.
- Cash Flow Statement: Net Income is up by $45, and we add back the $20 of Amortization of Intangibles since it was non-cash. However, we also make an adjustment of ($5) in Deferred Income Taxes because this Amortization is not Cash-Tax Deductible. So, Cash at the bottom is up by $45 + $20 – $5 = $60.
- Balance Sheet: Cash is up by $60, Other Intangibles are down by $20 due to the Amortization, and the Net DTA is up by $5 due to the Deferred Income Tax adjustment, so the Assets side is up by $45. On the L&E side, CSE is up by $45 due to the increased Net Income, so both sides are up by $45 and balance.
- Intuition: The acquired company contributes $100 in Operating Income, but it’s not a straight $75 increase to Cash because of the new Amortization and Interest Expense, which make it to a $45 increase instead.
On December 31 of Year 1, this same company now decides that this acquired company is worth far less than expected, so it writes down the entire $100 balance of Goodwill.
Walk through JUST THIS STEP BY ITSELF, ignoring the cumulative changes in the previous two steps. This one is a simple non-cash expense that is also not Cash-Tax Deductible:
• Income Statement: Record a $100 Goodwill Impairment, which reduces Pre-Tax Income by $100 and Net Income by $75 at a 25% tax rate.
• Cash Flow Statement: Net Income is down by $75, and you add back the $100 Goodwill Impairment. Also, since it was not Cash-Tax Deductible, record a ($25) adjustment in Deferred Income Taxes. Cash at the bottom is unchanged.
• Balance Sheet: Cash is unchanged, Goodwill is down by $100, and the Net DTA is up by $25, so Total Assets are down by $75. On the L&E side, CSE is down by $75 due to the reduced Net Income, so both sides are down by $75 and balance.
• Intuition: Impairments and write-downs are rarely, if ever, Cash-Tax deductible. So, when they occur, they increase the company’s DTA or Net DTA rather than increasing its Cash balance.
