Accounting Questions Flashcards
What is the primary purpose of US GAAP?
- Financial statements are required to be prepared in accordance with US GAAP
- Through standardized financial reporting and fair/consistent presentation, the interests of investors and lenders are protected
what are the main sections of a 10-k?
- Business Overview: business divisions, strategy, product or service offerings, seasonality, geographical footprint, and key risks
- Management’s discussion and analysis: Commentary and summarized analysis of the company’s fiscal year result from the perspective of management
- Financial statements: 3 core (IS, BS, CFS), Other 2 (statement of comprehensive income, statement of shareholders equity)
- Notes: disclosures to the financial statements that provide more details about a company’s recent financial performance
What are the differences between the 10-k and 10-q?
- 10-k: annual report, comprehensive, commentary by management, 3 core financial statements
- 10-q: quarterly report, far more condensed, quarterly financials, brief MD&A, and disclosures
- additional: 10-k is required to be audited by an independent accounting firm and must be filed ~60-90 days after fiscal year-end, 10-q is only reviewed by CPAs, left unaudited, and must be submitted ~40-45 days after the quarter-end
A brief walkthrough of the 3 core financial statements?
- Income Statement (IS): The income statement shows a company’s profitability over a specified period, typically quarterly and annually. The beginning line item is revenue and upon deducting various costs and expenses, the ending line item is net income.
- Balance Sheet (BS): The balance sheet is a snapshot of a company’s resources (assets) and sources of funding (liabilities and shareholders’ equity) at a specific point in time, such as the end of a quarter or fiscal year.
- Cash Flow Statement (CFS): Under the indirect approach, the starting line item is net income, which will be adjusted for non-cash items such as D&A and changes in working capital to arrive at cash from operations. Cash from investing and financing activities are then added to cash from operations to arrive at the net change in cash, which represents the actual cash inflows/(outflows) in a given period.
Walk me through the income statement
- The income statement shows a company’s profitability over a specified time period and facilitates the analysis of its historical growth and operational performance.
- It begins with revenue (often called the “top line”).
- Then COGS is subtracted from revenue to arrive at gross profit.
- Then Selling, General & Administrative (SG&A) and Research & Development (R&D) are subtracted from gross profit to get EBITDA.
- EBITDA stands for Earnings Before Interest, Taxes, Depreciation & Amortization.
- Then Depreciation & Amortization (D&A) are subtracted from EBITDA to arrive at operating income also known as (EBIT).
- EBIT stands for Earnings Before Interest and Taxes.
- Then Interest Expense from debt, net of interest income generated from investments brings us to Pre-Tax Income also referred to as (EBT).
- Lastly, Tax Expense is subtracted from pre-tax income to end at Net Income which is referred to as the “bottom line”.
Revenue
represents the total value of all sales of goods and delivery of services throughout a specified period
Cost of Goods Sold (COGS)
represents the costs directly tied to producing revenue, such as the costs of materials and direct labor
Selling, General & Administrative (SG&A)
operating expenses that are not directly associated with the good or service being sold (e.g., payroll, wages, overhead, advertising, and marketing)
Research and Development (R&D)
costs that come from developing new products or procedures to improve their existing product/service offering mix
Depreciation and Amortization (D&A)
non-cash expenses that estimate the annual reduction in the value of fixed and intangible assets
tax expense
Tax liability recorded by a company for book purposes
Walk me through the balance sheet
- The balance sheet shows a company’s assets, liabilities, and equity sections at a specific point in time. The fundamental accounting equation is: Assets = Liabilities + Shareholders’ Equity. The assets belonging to a company must have been funded somehow, so assets will always be equal to the sum of liabilities and equity.
- Assets are organized in the order of liquidity, with “Current Assets” being assets that can be converted into cash within a year, such as cash itself, along with marketable securities, accounts receivable, prepaid expenses, and inventories. “Long-Term Assets” include property, plant, and equipment (PP&E), intangible assets, goodwill, and long-term investments.
- The Liabilities are listed in the order of how close they’re to coming due. “Current Liabilities” include accounts payable, accrued expenses, and short-term debt, while “Long-Term Liabilities” include items such as long-term debt, deferred revenue, and deferred income taxes.
- The Shareholders’ Equity Section consists of common stock, additional paid-in capital (APIC), treasury stock, and retained earnings.
Could you give further context on what assets, liabilities, and equity each represent?
- Assets are resources with economic value that can be sold for money or bring positive monetary benefits in the future. For example, cash and marketable securities are a store of monetary value that can be invested to earn interest/returns, accounts receivable are payments due from customers, and PP&E is used to generate cash flows in the future – all representing inflows of cash.
- Liabilities are unsettled obligations to another party in the future and represent the external sources of capital from third parties, which help fund the company’s assets (e.g., debt capital, payments owed to suppliers/vendors). Unlike assets, liabilities represent future outflows of cash.
- Equity is the capital invested in the business and represents the internal sources of capital that helped fund its assets. The providers of capital could range from self-funded to outside institutional investors. In addition, the accumulated net profits over time will be shown here as “Retained Earnings.”
What are the typical line items you might find on the balance sheet?
Current Assets
- Cash & Cash Equivalents: includes cash itself and highly liquid, cash-like investments, such as commercial paper and short-term government bonds.
- Marketable Securities: are short-term debt or equity securities held by the company that can be liquidated to cash relatively quickly.
- Accounts Receivable: refers to payments owed to a business by its customers for products and services already delivered to them (i.e., an “IOU” from the customer).
- Inventories: are raw materials, unfinished goods, and finished goods waiting to be sold and the direct costs associated with producing those goods.
- Prepaid Expenses are payments made in advance for goods or services expected to be provided on a later date, such as utilities, insurance, and rent.
Non-Current Assets
- Property, Plant & Equipment (PP&E): Are fixed assets such as land, buildings, vehicles, and machinery used to manufacture or provide the company’s services and products.
- Intangible Assets: are non-physical, acquired assets such as patents, trademarks, and intellectual property (IP).
- Goodwill: Is an intangible asset created to capture the excess of the purchase price over the fair market value (FMV) of an acquired asset.
Current Liabilities
- Accounts Payable: represents unpaid bills to suppliers and vendors for services/products already received but were paid for on credit.
- Accrued Expenses: are incurred expenses such as employee compensation or utilities that have not been paid, often due to the invoice not being received.
- Short-Term Debt: is debt payments coming due within twelve months, with the current portion of long-term debt also included.
Non-Current Liabilities
- Deferred Revenue: is unearned revenue received in advance for goods or services not yet delivered to the customer (can be either current or non-current).
- Deferred Taxes: are tax expenses recognized under GAAP but not yet paid because of temporary timing differences between book and tax accounting.
- Long-Term Debt: is any debt capital with a maturity exceeding twelve months.
- Lease Obligations: are long-term contractual agreements, allowing a company to lease PP&E for a specific time period in exchange for regular payments.
Shareholder’s Equity
- Common Stock: represents a share of ownership in a company and can be issued when raising capital from outside investors in exchange for equity.
- Additional Paid-In Capital (APIC): represents the amount received in excess over the par value from the sale of preferred or common stock.
- Preferred Stock: is a form of equity often considered a hybrid investment, as it has features of both common stock and debt.
- Treasury Stock: Refers to shares that had been previously issued but were repurchased by the company in a share buyback and are no longer available to be traded.
- Retained Earnings: Represents the cumulative amount of earnings since the company was formed, less any dividends paid out.
- Other Comprehensive Income (OCI): consists of foreign currency translation adjustments and unrealized gains or losses on available-for-sale securities.
Walk me through the cash flow statement
the cash flow statement is broken out into three sections:
- Cash from Operations: This section starts with net income and adds back non-cash expenses such as depreciation & amortization and stock-based compensation, and then makes adjustments for changes in working capital.
- Cash from Investing: This section accounts for capital expenditures (typically the largest outflow), followed by any business acquisitions or divestitures.
- Cash from Financing: This last section shows the net cash impact of raising capital from issuances of equity or debt, net of cash used for share repurchases, and repayments of debt. The cash outflows from the payout of dividends to shareholders will be reflected here as well.
- Together, the sum of the three sections will be the net change in cash for the period.
- This figure will then be added to the beginning-of-period cash balance to arrive at the ending cash balance.
How are the three financial statements connected?
IS ↔ CFS: The cash flow statement is connected to the income statement through net income, as net income is the starting line on the cash flow statement.
CFS ↔ BS: Next, the cash flow statement is linked to the balance sheet because it tracks the changes in the balance sheet’s working capital (current assets and liabilities). The impact of capital expenditures (PP&E), debt or equity issuances, and share buybacks (treasury stock) are also reflected on the balance sheet. In addition, the ending cash balance from the bottom of the cash flow statement will flow to the balance sheet as the cash balance for the current period.
IS ↔ BS: The income statement is connected to the balance sheet through retained earnings. Net income minus dividends issued during the period will be added to the prior period’s retained earnings balance to calculate the current period’s retained earnings. Interest expense on the income statement is also calculated off the beginning and ending debt balances on the balance sheet, and PP&E on the balance sheet is reduced by depreciation, which is an expense on the income statement.
If you have a balance sheet and must choose between the income statement or cash flow statement, which would you pick?
Assuming that I would be given both the beginning and end of-period balance sheets, I would choose the income statement since I could reconcile the cash flow statement using the balance sheet’s year-over-year changes along with the income statement.
Which is more important, the income statement or the cash flow statement?
The income statement and cash flow statement are both necessary for any in-depth analysis. However, the cash flow statement is arguably more important because it reconciles net income, the accrual-based bottom line on the income statement, to what is actually occurring to cash.
This means the actual movement of cash during the period is reflected on the cash flow statement. Thus, the cash flow statement brings attention to liquidity-related issues and investments and financing activities that don’t show up on the accrual-based income statement.
If you had to pick between either the income statement or cash flow statement to analyze a company, which would you pick?
In most cases, the cash flow statement would be chosen since the cash flow statement reflects a company’s true liquidity and is not prone to the same discretionary accounting conventions used in accrual accounting. A company’s ability to generate sufficient free cash flow to reinvest into its operations and meet its debt obligations comes first.
However, for an unprofitable company, the income statement can be used to value the company based on a revenue multiple. The cash flow statement becomes less useful for valuation purposes if the company’s net income, cash from operations, and free cash flow are all negative.
Why is the income statement insufficient to assess the liquidity of a company?
The income statement can be misleading in the portrayal of a company’s health from a liquidity and solvency standpoint.
For example, a company can consistently show positive net income yet struggle to collect sales made on credit. The company’s inability to retrieve payments from customers would not be reflected on its income statement.
Also, financial reporting under accrual accounting is imperfect in the sense that it often relies on management discretion. This can increase the risk of earnings management and the misleading depiction of a company’s actual operational performance.
The cash flow statement solves this because it reconciles net income based on the real cash inflows/(outflows) to understand the true cash impact from operations, investing, and financing activities during the period.
What are some discretionary management decisions that could inflate earnings?
- Using excess useful life assumptions for new capital expenditures to reduce the annual depreciation
- Switching from LIFO to FIFO if inventory costs are expected to increase, resulting in higher net income
- Refusing to write down impaired assets to avoid the impairment loss, which would reduce net income
- Repurchasing shares to decrease its share count and artificially increase earnings per share (“EPS”)
- Deferral of capex or R&D to the next period to show more profitability and cash flow in the current period
- More aggressive revenue recognition policies in which the obligations of the buyer become less stringent
Tell me about the revenue recognition and matching principle used in accrual accounting.
Revenue Recognition Principle: Revenue is to be recorded in the same period the good or service was delivered, whether or not cash was collected from the customer.
Matching Principle: The expenses associated with the production/delivery of a good or service must be recorded in the same period as when the revenue was earned.
How does accrual accounting differ from cash-basis accounting?
Accrual Accounting: revenue recognition is based on when it’s earned and the expenses associated with that revenue are incurred in the same period.
Cash-Basis Accounting: Under cash-basis accounting, revenues and expenses are recognized once cash is received or spent, regardless of whether the product or service was delivered to the customer.
What is the difference between cost of goods sold and operating expenses?
Cost of Goods Sold: represents the direct costs associated with the production of the goods sold or the delivery of services to generate revenue. Examples include direct material and labor costs.
Operating Expenses: such as SG&A and R&D are not directly associated with the production of goods or services offered. Often called indirect costs, examples include rent, payroll, wages, commissions, meal and travel expenses, advertising, and marketing expenses.
When do you capitalize vs. expense items under accrual accounting?
The factor that determines whether an item gets capitalized as an asset or gets expensed in the period incurred is its useful life (i.e., estimated timing of benefits).
Capitalized: Expenditures on fixed and intangible assets expected to benefit the firm for more than one year need to be capitalized and expensed over time. For example, PP&E such as a building can provide benefits for 15+ years and is therefore depreciated over its useful life.
Expensed: In contrast, when the benefits received are short-term, the related expenses should be incurred in the same period. For example, inventory cycles out fairly quickly within a year, and employee wages should be expensed when the employee’s services were provided.
If depreciation is a non-cash expense, how does it affect net income?
While depreciation is treated as non-cash and an add-back on the cash flow statement, the expense is tax-deductible and reduces the tax burden. The actual cash outflow for the initial purchase of PP&E has already occurred, so the annual depreciation is the non-cash allocation of the initial outlay at purchase.
Do companies prefer straight-line or accelerated depreciation?
For GAAP reporting purposes, most companies prefer straight-line depreciation because lower depreciation will be recorded in the earlier years of the asset’s useful life than under accelerated depreciation. As a result, companies using straight-line depreciation will show higher net income and EPS in the initial years.
Eventually, the accelerated approach will show lower depreciation into an asset’s life than the straight-line method. However, companies still prefer straight-line depreciation because of the timing, as many companies are focused more on near-term earnings.
What is the relationship between depreciation and the salvage value assumption?
Most companies use a salvage value assumption in which the remaining value of the asset is zero by the end of the useful life.
The difference between the cost of the asset and salvage value is known as the total depreciable amount. If the salvage value is assumed to be zero, the depreciation expense each year will be higher and the tax benefits from depreciation will be fully maximized.
Straight Line Annual Depreciation = (Asset Historical Cost−Salvage Value) / Useful Life Assumption
Do companies depreciate land?
While classified as a long-term asset on the balance sheet, land is assumed to have an indefinite useful life under accrual accounting, and therefore depreciation is prohibited.
How would a $10 increase in depreciation flow through the financial statements?
The depreciation expense will be embedded within either the cost of goods sold or the operating expenses line item on the income statement.
IS: When depreciation increases by $10, EBIT would decrease by $10. Assuming a 30% tax rate, net income will decline by $7.
CFS: At the top of the cash flow statement, net income has decreased by $7, but the $10 depreciation will be added back since it’s a non-cash expense. The net impact on the ending cash balance will be a positive $3 increase.
BS: PP&E will decrease by $10 from the depreciation, while cash will be up by $3 on the assets side. On the L&E side, the $7 reduction in net income flows through retained earnings. The balance sheet remains in balance as both sides went down by $7.
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?
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.
What is the difference between growth and maintenance capex?
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).
Which types of intangible assets are amortized?
Amortization is based on the same accounting concept as depreciation, except it applies to intangible assets rather than fixed tangible assets such as PP&E. Intangible assets include customer lists, copyrights, trademarks, and patents, which all have a finite life and are thus amortized over their useful life.
What is goodwill and how is it created?
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.
Can companies amortize goodwill?
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.
What is the “going concern” assumption used in accrual accounting?
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.
Explain the reasoning behind the principle of conservatism in accrual accounting.
The conservatism principle requires thorough verification and the 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.
Why are most assets recorded at their historical cost under accrual accounting?
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.
What role did fair-value accounting have in the subprime mortgage crisis?
In the worst-case scenario, sudden drops in asset values could cause a domino effect in the market. An example was the subprime mortgage crisis, in which the meltdown’s catalyst is considered to be FAS-157.
This mark-to-market accounting rule mandated financial institutions to update their pricing of illiquid securities. Soon after, write-downs in financial derivatives, most notably credit default swaps (CDS) and mortgage-backed securities (MBS), ensued from commercial banks, and it was all downhill from there.
Why are the values of a company’s intangible assets not reflected on its balance sheet?
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.
